Business Essentials for Startups

Markets come and go. Good business don’t.

Return on Investment

Calculate a return on investment (ROI) the right way.

source: avc.com

Time Value of Money

Money today is generally worth more than money tomorrow. The value of money increases through time with an interest rate.

The power of compound interest comes from re-investment of interest payments. You refuse to take money out today in order to obtain much more money in the future.

Incorporate

Incorporating creates a buffer between you and your business in terms of liability, taxes and ownership for investment.

In U.S., there are two basic kinds of corporate entities for taxes:

“Flow-through entities”: company doesn’t pay taxes but pass the income and tax obligation to the owner;

“Tax paying entities”: company pays taxes and the owner has no obligation to the taxes owed.

In U.S., there are different kinds of business entities.

First, LLC, a flow through entity with limited liability composed of “members”. It is most popular corporate form among startups.

Second, C Corporation, a tax paying entity with limited liability and ownership structure. Most public companies and venture backed companies are C Corps.

Third, S Corporation, a hybrid between C Corp and LLC, a flow through entity with limited liability and simple ownership structure requiring less than 100 shareholders.

Last, Limited Partnership (LP), a flow through entity where investors have limited liability but managers (General Partners) don’t.

Beware threats of piercing the corporate veil. You can’t pretend to be a business, you have to be a business. It means separating your personal and business records, separating your personal and business bank accounts, treating the business as a real entity, having board meetings, taking board minutes, doing major activities through board resolutions and following “due process”.

Accounting Basics

Accounting is keeping track of the money in a company. Every financial transaction of a company must be recorded. Chart of accounts includes income/expense accounts and asset/liability accounts. Double entry accounting means every transaction changes both accounts. The entry must balance out.

The Profit and Loss Statement (P&L) is a report of the revenue/expense accounts. A Google’s example is shown below:

source: avc.com

The highlights include revenue recognition, accrual accounting, expense segmentation, gross margin, income from operations, and net income.

The Balance Sheet is a report of the asset/liability accounts, which shows how much capital you have built up in your business. A Google’s example is shown below:

source: avc.com

The highlights include Total Current Assets, Property Plant and Equipment, Goodwill, Accounts Payable and Accrued Expenses.

You can evaluate how business is going on by comparing Total Current Assets and Total Current Liabilities. For balancing out, Total Assets must equal Total Liabilities plus Stockholders Equity.

The Cash Flow Statement is a report of the amount of cash your business produces or consumes in a given period. It is different from profits (revenue-expense) because they are not synchronous.

To calculate cash flow in a simplified version, you start with Net Income, subtract the increase of Current Assets, subtract the increase of Non-current Assets, add the increase of Current Liabilities, add the increase of Long-term Liabilities, and add the increase of Stockholders Equity.

The reason to separate the terms is that this way tells you where your cash is produced or consumed.

Dig Financial Statements

Here are a few guide lines for analyzing your financial statements (P&L, Balance Sheet, and Cash Flow):

• Cash is the king. Always remember how much cash you currently have.
• Calculate the average cash flow over a year. Back out all debts.
• If the average cash flow is negative, figure out how many months of cash you have left.
• Look how important items (revenue, gross margin, operating costs, operating income) in your income statement are going through time. Back out “one-time items”.
• Compare the monthly operating income and monthly cash burn. If they are not close, look at the non-cash assets and liabilities in the balance sheet. Figure out how it is moving month over month.
• If it is sucking your cash, find if the revenue is real, then figure out the availability of working capital financing.
• Look at the Capex in the balance sheet. If it is growing faster than the profits, it’s got potential problems. The availability of financing is the key to solving it.

In summary, you need to figure out these numbers:

• Current Cash Balance
• Cash Burn Rate, or Cash Flow Rate
• Months of Runway
• Income vs. Time
• Working Capital
• Capex

Key Business Metrics

Every business should have a handful of key metrics that it tracks on a regular basis. These metrics are usually the drivers for revenue and growth, sometimes even the cost center.

The metrics vary between companies. For Meetup, it is successful Meetup groups. For Twitter, it is all about the tweets. For Etsy, it is customer service. When you are talking about key business metrics, less is more.

Tracking key business metrics is extremely important to keep everyone on the same page and build a strong culture.

Projections, Budgeting and Forecasting

Projection matters in the following three reasons:

• Company is valued by its future.
• Used for goal and expectation setting.
• Tells you what the financing needs are.

There three kinds of projections:

• Projections: a set of numbers about the big picture of your business
• Budgets: a set of numbers planned for outlining what to achieve next year.
• Forecasts: iterations of budgets based on what is likely to occur

Scenario-driven analysis is a practical process for making better projections and identifying key business drivers. After you have a set of key business metrics in spreadsheet, you can make assumptions about them using the three following scenarios:

• Best case: what you think it will ever be
• Base case: what you truely expect it to be
• Worst case: nightmare scenario, the worst it could ever be

Budgeting is pretty much a refinement process or an operating framework for projections. Generally, the larger the company is, the earlier the budgeting process should start.

For a small early-stage 10-ish-people startup:

• Starts with a financial model built by projections.
• Review the key business metrics and lock them down based on very realistic and conservative predictions.
• The main focus is hiring and people costs.
• Emphasize on your cash.
• Keep transparent with your team about the budget.
• Measure it against real performance.

For a growing 50-ish-people company:

• Hire a financial lead (CFO/VP Finance) to run the process for you.
• Start with revenue plan/model and do it bottom-up. Beware the optimism of your sales lead.
• Once a set of revenue numbers are ready, lay out all the KPIs that it will take to hit them. It is time-consuming, but KPI is the bridge between revenue model and cost model.
• Form the comprehensive cost model including headcount and capex from KPIs.
• Be transparent and converged with your team.
• Be prepared that very few budgets are met in reality.

For a large company of 150 employees or more:

• Have your finance lead and all senior members involved in budgeting process.
• Have the revenue model with segmentation with help of finance team and sales team.
• KPIs are still the most important part, and cost budgeting can be as exhaustive as possible.
• Benchmark the budget numbers with other companies in the industry.

Forecasts should be done whenever the actual performance differs much from the budgets; yet, the forecasts should exist beside the budget. Forecasts are basically adjustment based on your financial model, combined with actual performance, and generate a new set of numbers. Keep it updated. Forecasting to the budget is like iteration to the releases in agile development.

In summary, projections, budgeting and forecasting are “long-term”, “short-term” and “real-time” breakdowns for what is going to happen for the business.

Risk & Return

Risk and return are correlated. Financial theory often uses Capital Asset Pricing Model (CAPM) to describe the relationship between risk and return. It says:

Expect Return on an Asset = Risk-free Rate + beta * (Expect Market Return - Risk-free Rate)

Where beta is defined as:

beta = Covariance(asset, portfolio) / Variance(portfolio)

We often call the difference between expect asset return and risk free rate as Risk Premium, and the difference between expect market return and risk free rate as Market Premium. Therefore, we have a different form of CAPM:

Risk Premium / Market Premium = beta

Generally, if the beta is high, you are taking risks for a higher return. Remember, it is possible that you will lose partial or total investment money.

Thus, diversification is really important for risk mitigation. In finance, Portfolio Theory says that you can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated with each other. In short, you can’t put all of the eggs into one basket. Put some into other places, or put something not eggy into that basket.

Hedging is another method to mitigate risks. The two main operations for hedging is shorting and option trading. For example, if you hold some shares of a stock but you don’t want to sell them, here are some ways to protect your downside (but perhaps sacrifice your upside):

• Short the stock. Borrow some shares of the stock for others, and pay back the same amount of shares later.
• Buy a put option: the right to put your stock to someone at a specific price. You can find price quotes in CBOE.
• Sell a call option: the right to all someone for stock at a specific price.
• “Collar”: buy a put option at lower price, and sell a call option at higher price.

Always remember that there is counterparty risk when doing hedging. The other party to the transaction might bankrupt. It is like an insurance issuer.

If you are going to expand your company internationally, which means you will have other currency denominated revenues and expenses, you need to think about currency risk. Dropped currency rate can lower your revenues as well as lower your expenses. You can naturally hedge them by matching revenues and expenses denominated by other currency.

Regarding the currency risk, how do we evaluate the “fair” currency rate? Purchasing Power Parity says a basket of goods traded between markets should cost the same. We can use it to calculate the fair currency rate and evaluate if a currency is overvalued or undervalued compared to another one.

Invisible Costs and Liabilities

Balance sheet and income sheet cannot tell you all things. There are many costs and liabilities off the sheet.

First, opportunity costs. It is the cost you choose not to do something else. For example, you allocate all your resources to progress project A, then you have a opportunity cost on possibly project B.

Second, sunk costs. It is the cost you’ve already spent, and it is not logically relevant to your next decision. Remember, you should never make a decision based on sunk costs. (Yet, you will still learn this the hard way)

Last but not the least, off balance sheet liabilities. Enron’s case is an illegal example, but you may still have it if you are clean and honest:

• Liability from not meeting the requirements of a deal.
• Liability from over-cost for meeting the requirements of a deal.
• Real estate liability, like long-term lease.

The footnotes are where you have to go to see the off balance sheet liabilities, if the company is audited. If the company is private, you have to diligence the unreported liabilities yourself, and that’s why due diligence is so important to close a funding.

Market Value & Enterprise Value

Market value is simply the price you are paying for the entire company in stock market.

Market Value = Total shares outstanding * Current market price per share

Enterprise value is the price of a company without cash and debts.

Enterprise Value = Market Value - Current Cash + Current Debt

If you need to calculate multiples (e.g. market revenue profit multiple) for evaluating the company, you’d better use Enterprise Value instead of Market Value.

In real life, you calculate the “fair market value” on FAS 157, a U.S. accounting standard.

What A CEO Does

A CEO does three things:

• Set the vision and strategy, communicate it to all stakeholders
• Recruit, hire and retain the best talents
• Make sure there is enough cash in the bank

Besides the top principles, there are a few important bonus points:

• Get your hands dirty in market/customers/industry/competitors
• Don’t be a bottleneck for other people’s processes
• Run efficient, short, less meetings
• Keep yourself fresh.

Employee Equity

Employee equity is a form of employee ownership, which is important to startup culture. Different types of businesses and founders might set different shares for employee equity, but the general sweet spot is around 20%.

There are four primary ways to issue employee equity in startups:

• Founder stock: common stock with special vesting provisions
• Restricted stock: common stock with vesting provision, has tax issue
• Options: most common form, the right to purchase stock at set price
• Restricted Stock Units (RSUs): the promise of issuing stock when vested

Employee equity is diluted over time. Usually the earliest shareholders take most dilutions. Dilution comes from the following activity:

• Early employees stocks.
• A funding round is done. Seed, Series A, etc..
• Option pool and its refresh (keeping it at ~10%).
• M & A

Dilution is the decline of the stock shares, but it often moves with the appreciation of the stock price. Startup starts with zero value, then venture capital business comes to value the price in a series of rounds. Note that the price doesn’t always rise, and it can decline or be flat. But if the business is successful, the employee equity will appreciate over the long run.

Most startups have two kinds of stocks:

• Common stock
• Preferred stock

Most VCs like to have preferred stock because it has liquidation preference. When the company sells itself, the owner of preferred stock has the right to get the amount of money they invested or the percentage of the shares, whichever is more (often, there is even a 2x/3x multiple for liquidation preference).

When a company sells itself under its previous valuation, investors will get their invested money back, the founders and employees will get less than their shares. When a company sells itself under the investment, it faces liquidation overhang. Investors get all money back (but still lose some), and employee equity is worth nothing. The best strategy to resolve liquidation overhang is to continue to grow out of it (i.e. has a higher value than liquidation preference).

A stock option is the right to purchase stock at the strike price for a fixed period of time. Most startups prefer stock option over restricted stock for tax reason. When restricted stock is vested, the employee must pay tax on it; while if a stock option is vested, the employee doesn’t pay tax on it because it is “at the money” and has no exercise value.

Option is usually coupled with 4-year vesting for talent attraction and retention, because the options are granted the first day (lowest strike price) but vested over 4 years. Employees often exercise their options (and pay taxes) when a liquidity event happens, or they leave the company. In the latter case, they are asked to exercise the options in a short period after leaving.

Most companies has an incentive to set the strike price of the option low to attract talents, but the Board actually has the obligation to set it at the “fair market price”. It is regulated by the 409a rule issued by IRS. Since the 409a ruling allows 3rd party valuation, it has the following effects:

• The company has to pay money to the 3rd party valuation firms periodically
• The company has to update 409a valuation after a financing round, thus may delay the issuance of employ options for update strike price.
• New hires might get screwed after a big up round or 409a overdue.

Restricted Stock is pretty straightforward. The company issues common stocks to employee with restrictions. Two important restrictions are:

• A vesting schedule. Usually over 4 years with 1 year cliff.
• A right of first refusal on sale for the company.

The downside of restricted stock is taxation. Employee needs to pay taxes based on fair market value for illiquid stock upon vested. It only makes sense when the stock value is nominal (early employees) or the employee is willing to do so. “83b election” is filed to pay taxes on grant instead of vest. So the founders should file “83b election” since the taxes are nominal.

Restricted Stock Unit (RSU) is a combination of stock option and restricted stock. Employee gets a promise of issuance of common stock upon vested, but offers a delay of receipt of the common stock until the stock is liquid. The good and bad thing is that RSU is still not regulated by IRS.

Vesting is the technique to allow employees to earn equity over time. The common practice is 4 year vesting with one year cliff, and retention grant after 2-year service (so that no one is more than half vested on their equity). One year cliff allows the company to move a bad hire out without much dilution with two exceptions: 1) if an employee is fired close to anniversary, you should vest part of the equity; 2) the company is on sale.

When the company is on sale, the accelerated vesting upon change of control benefits employees but may compromise the company. There are different choices: partial acceleration vs. full acceleration, and single trigger vs. double trigger. It is recommended to use “double trigger” for vesting acceleration: change of control, and role termination/demotion.

For your first key hires, you may have to talk about points of the equity, but once you are operating a real business, you need to move away from points of equity as soon as possible (it is really expensive) and give out equity in terms of “best” dollar value. For different levels of hires, you will have different equity/base multipliers. An example is the following:

• Senior Management Team: 0.5x (their base salary)
• Director Level: 0.25x
• Key Functions: 0.1x
• Others: 0.05x

Using these multipliers, you can calculate the dollar value of given equity. Then, you need to calculate their shares:

Number of Shares = Dollar Value of Employee Equity/ Per-share Price

And also, use the same formula for the retention grant. The rule of thumb is that it should roughly equal to the dollar value of unvested equity.

M & A

There two types of deals:

• Acquisitions: A company is taking control of the other. Most common.
• Mergers: Two similar sized business combine.

Regarding how the consideration is paid, there are three ways: cash deal, stock deal, and debt (less common in startup world).

In terms of what the acquirer is purchasing, the acquirer can either purchase the entire company via its stock, or its select assets (“asset deal”).

Asset sales can happen as a partial exit, or a complete exit. It is desirable in a partial exit, because it often helps the seller company simplify its businesses. It is not desirable in a complete exit, the seller company has to unwind the leftover and liquidate itself. Asset sales also cause tax issues, since the remaining cash after settling liabilities might be double taxed in both company level and liquidating distribution. In general, asset sales are desirable for acquirers but not desirable for the seller company unless it is in the“fire sale” situation.

When selling the entire company, there are a few key factors to consider:

• Price
• Consideration
• Reps, warranties, indemnities and escrow
• Integration plan
• Stay packages
• Governmental approval
• Breakup fees
• Timing

Integration plan is the buyer plans to operate the business post acquisition. There are several important aspects to set up integration plan before signing the Stock Purchase Agreement(SPA):

• “leave it alone” vs. “integrate into the organization”
• keep the key people. At least, stay until a new team is formed.
• manage the conflicts between the acquired company and the buyer’s existing efforts

The stay package depends on the equity value and vesting:

• Mostly not vested: use the remaining unvested equity as part of packages
• Mostly vested: grant new equity or cash bonus for key people
• Mostly worthless: carve-out part of total consideration for stay packages

When two large business combine, the governmental approvals become important, because they can prevent the merger from happening. It usually happens to a large transaction due to anti-trust investigation, and the main offices are DOJ/FTC. Be careful, it may mess with your deal.

A breakup fee is the payment made by the buyer to the seller if the transaction doesn’t close. It is usually negotiated in a large deal as an important term. The seller wants to limit the risks of internal and external disruptions, and forces the buyer to signal the seriousness of its interest.

In a transaction, a contract has many components. Representations (reps) are what is true today. Warranties are what is true about the future. An indemnity is the money paid to the buyer if any of reps and warranties turn out to be false. An escrow is the money the buyer holds for insuring possible indemnities. Just read them carefully. Have lawyer’s help if necessary.

Timing refers to how long it takes from the first serious conversation to closing. Six weeks are ideal. Anything beyond three months is too long. Remember, the team suffers when the sale process are stretched.

Consideration is the form of payment. You can get paid in multiple ways. Cash is usually best and most common. Stock is attractive if you are pursuing the upside, but remember the private stock can be worthless. Note is generally the least attractive. Cash + Stock is also a very common way.

Finally, Price is the big issue. The best way to get the highest price is to have a competitive process with multiple bidders (but don’t go too far). Preemptive offers (no competitors) are ok if you know the price is good. Financial people can help you have a fair valuation, but don’t sell your company just because there is a good price.

Margins

Margins are the amount of money you make on each incremental sale before considering the fixed costs, which are the money you have to pay regardless of selling anything. It is also called gross margin.

Different companies have different margin structures. A few examples:

• Apple iPad: sale price - BOM cost, medium margin
• Amazon retail: sale price - purchases from manufacturers, low margin
• Google search: small additional cost per query, high margin
• Salesforce: almost no additional cost per software sale, very high margin

In general, high margin businesses are easier to grow and manage, while low margin businesses are often difficult to scale.

Another type of margin is operating margin, which is related to operating costs. Businesses can perform differently on various margins. For instance, Apple has a relatively low gross margin but a nice operating margin, while Salesforce has a very high gross margin and a very low operating margin.

Financing Options

Financing is obtaining cash to fund your business. There are many ways.

Friends and family financing is probably the most common way, because it is relatively easy. But it is not a lot of money and difficult for pricing. The trickiest part is that you don’t want them to lose money, and even worse, the relationship. Be very clear to them about the risk and downside, and use convertible notes with a discount and a cap on the valuation.

Contests, prizes and accelerator programs may give you some money for a few shares. It is like a great first stair for entrepreneurs, having enough money to step up to the next stair.

Governmental grants are sort of “free capital”. No paid back or equity. But there are some constraints on your business and where and how you do the business. The application process is usually tedious, and the money is often never enough to really move the needle.

Customers are a great way to finance a business on its own. They are more interested in the product instead of the equity. They help you debug and fit product to market. Most of time the early customers give you money based on the prototype of your product, and simply want the product and no more. However, you may compromise the scaleability of your business.

Vendor financing is about getting your suppliers to fund your business. It is more common for capital intensive industries like bio-tech or clean-tech. One example is equipment financing, when a vendor of capital equipment sells you their product and takes a loan or a lease instead of cash. Another example is development for equity, when a third party development firm builds something for you and takes equity or a loan in your business.

Convertible debt is a debt intentionally converted to equity at some later date. Startups like it because it will dilute less equity. Family and friends like it because they are not professional negotiators. Some investors like it when they are so eager to enter this round. Convertible debt often comes with compensations: warrants (like options) or discount or cap. A “xx% warrant coverage” offers extra xx% warrants during conversion. A “xx% discount” offers 1-xx% price for shares during conversion. A cap limits the maximum valuation on which the conversion is based.

Almost all VCs invests in preferred stock. Preferred stock is a class of stock that provides certain rights, privileges and preferences to investors. We are talking about liquidation preference (1x, 3x, etc.), participating preferred, a right to board seat, information rights, pro-rata right, a right of first refusal, co-sale right and anti-dilution right. Remember, whatever you agree to with a set of investors, will probably what all future investors want.

Venture debt is a debt that banks and financial institutions provided usually with 3-year term, interest only, balloon payment (pay the loan at expiration) with warrants for the equity kicker. The lenders are loaning against the creditworthiness of VC, not startups. They are betting VC will keep funding. So it is more appropriate for late-stage startups than early-stage ones.

Capital equipment provides an opportunity for debt financing because you can borrow against the equipment, and it can be either loans or leases. Loans are offered by banks, where you own both the equipment and obligations. Leases are often offered by manufacturers, where you rent the equipment, pay monthly fee and have the option to buy it in the end.

Bridge loans are short term loans offered by VC or banks intended to bridge to somewhere or some events. Often it is a bad thing because the startup is going to run out of business but investors are trying to save it, and investors don’t get returns on bridge loans. Sometimes it is useful if investors anticipate the startup is going to sell itself in the future.

Working capital is current assets minus current liabilities. Working capital financing is design to deal with working capital issues that many inventory startups face, where they get money on paper but don’t have enough cash to meet the demand. It is often loaned by banks with a discount against your working capital.

Revenue-based financing is a good fit for a company that has already generated revenues without many hard assets. Investors will get realized returns periodically from a percentage of revenues, and founders won’t worry about dilusions and loss of control.

EBITDA

EBITDA stands for “Earnings Before Interest Taxes Depreciation and Amortization”.

This concept is originated in Leverage Buyout (LBO) world. It measures the maximum interest that you can pay to wipe out all taxes. For example, you want to buy a company with 5M EBITDA by borrowing money from banks and paying their interests by future earnings. If the interest rate is 5%, the maximum amount of money that you can borrow is 5M / 5% = 100M. In this case, you don’t pay taxes since all earnings are used to pay interest.

In business world, we use EBITDA to measure pre-tax cash earning power of a company (some people would prefer EBIT). In addition, Enterprise Value/EBITDA is a useful metric for valuing a company (based on the difficulty of LBO).

Cap Table & Liquidation Analysis

When you start a company or receive money from VC, you need to define (or re-define) share structure of the company, known as Capitalization Table (cap table). First, co-founders own an arbitrary number of common stock, say 1 million shares. Then, for each investment, calculate the number of preferred shares (series A, B, C, etc.): investment/share-price. Then, add the option pool. Finally, figure out the percentage of co-founders and all shareholders and option pool.

When you sell your company, you need a Liquidation Table, because a VC usually has liquidation preference (1x to 3x). For a given sale price, start with the most senior, preferred shareholders, calculate their money with options of liquidation preference. If any money is left, move to less senior shareholders. Repeat the process till the last one, common shareholders (founders and employees).

To understand what you can get in a liquidation event, you can do a liquidation analysis. Basically, you calculate liquidation table for a sale price from 0 up to the value that liquidation preferences are not executed. You will usually find that you do not get a lot of money in a liquidation event.

The Management Team

While building product, the team size should be ≤ 5:

• CEO is the product manager and/or designer
• 2~3 developers
• 1 designer if necessary

After product launch, the team starts building usage:

• Lead engineer is going to be a managing engineer
• Scale your engineering team & hire operation people
• CEO will be in a management crisis
• Invest in management

Finally the team is mature enough to become a real company building the business (although most startups won’t be lucky to reach this stage):

• Building a company is like building the ultimate product
• Building the business is building a management team
• Culture and values are not bullshit

The Board of Directors

The Board is the governing body for a company but should not run the company themselves. The Board work for the company and must always put the interests of the company first because that is their fiduciary responsibility. The Board put the key issues on the table and discuss them. The Board are fluid and peers to the CEO, but should never be controlled by the CEO or the co-founders or some shareholder’s interest.

The shareholders elect the Board of Directors. At first, there are 2 or 3 people including the founder(s). With investors involved, some investors will have a Board seat (by Shareholders Agreement). With more investors coming in, the company needs independent directors to balance interest conflicts. The Board needs to evolve as the company goes further.

The Board Chair runs the Board of Directors, makes sure the Board does what it is supposed to do, and coordinates between CEO and the Board. One can learn great skills from the Board Chairs of many non-profit organizations, as their Board is really huge and messy.

The chemistry among the Board members is criticial to the company. You need to continuously invest a lot in chemistry after you’ve assembled the Board. A very difficult thing is to remove or replace a Board member that doesn’t fit in, even when the person has contractual right or a senior partner of a investment firm. But you have to do the right thing for the company.

The Board meeting is how it becomes functional. 2 meetings per quarter is a recommended frequency (mid-quarter & end-quarter). An effective Board meeting cannot be one-directional information flow like reporting, but a semi-structured discussion on a few rough topics. Don’t let agenda ruin the Board meeting, because it is supposed to solve problems for the CEO and senior management team.

Any Board that is large enough should have committees for specific functions. The audit committee provides oversight of CFO function. The compensation committee makes the compensation plan right and manages the equity plans. The governance committee recruits and nominates directors. A committee is usually composed of a chair and two members.

People

Take culture and fit seriously. They are the very foundation of the company. You don’t hire for the best, but really hire for the culture and fit. It is like a jigsaw puzzle, you start with what you have in the company, and look for the right pieces that will fit nicely. If you make a bunch of bad hires (which you do), it will be your fault, not theirs.

So, where to find the talents:

• People you know. People your team know.
• Competitors.
• Companies that are purchased recently.
• Other parts of the country, and the rest of the world.
• College internship: young and scrappy people.
• Early employees in big companies.
• Get help from your investors.

The headcount depends on the stage of the company. The rule of thumb for internet startups is that 5 when you are building product, 10 when you are finding product/market fit, and 25 when you are growing the business. It is better to hire slowly and wisely than hire fast and fail.

You need to make hiring a process and take it very seriously. You need to have a system for posting openings and tracking candidates. You need to proactively look for candidates, interview them by your engineers and yourself. Sometimes you need to train your engineers interview skills. Once you identify a good candidate, do your homework for background check, and have your lawyer help to prepare an offer letter.

Then, you need to retain your employees. Here are some advices:

• Communicate
• Get the hiring process right and avoid bad hires
• Culture and fit matter
• Promote from within, create career paths for them
• Assess yourself, your team and your company
• Pay your team well

Sometimes, you need to ask someone to leave the company, and it is never easy. Here are some simple rules:

• Be quick and get it done
• Be generous to the employee even if you don’t have to
• Be clear and honest
• Get advice from HR and lawyers
• Communicate it to those who will be affected in the company

Sustainability

If you want to stay in business forever, you have to focus on the long term. Entrepreneurs are different from executives because executives would not be around the company for very long but entrepreneurs treat their companies as babies (you want to see them grown). You need to have the courage to disrupt your business rather than maximizing the profit.

The market is constantly changing, and you have to adapt to it. You probably won’t have a moment for any victory because things are changing. It is hard to be flexible because any organization has built-in inertia.

Cultures and values are serious for sustainablitiy. Your team must be the true believers. Don’t hire mecenaries. Kick out doubters.

Revenue Models

Advertising. There are two kinds of ads, ads that are sold and ads that are bought, and the latter becomes the trend. A tradeoff in ads is to go scale or go niche. Scale is about low price in very high CPM, while niche is about slightly higher price in slightly smaller CPM. But in anyway, scale matters.

Commerce. Basically, sell something to someone. There are three major types of commerce: retailing, marketplaces and direct-to-customer. Retailing is you buy product at wholesale and sell it at retail and earn your gross margin. In the marketplaces, you connect sellers to buyers and earn commissions. Direct-to-customer means you produce stuff and sell it to customers.

Subscriptions. Users pay subscription fees monthly or annually for using services. It works really well because it creates a favorable cash flow dynamic in the business, and the company can book most revenue for the year in advance. One special case of this model is “freemium”. The key to subscriptions model is reducing churn.

P2P. This model relies on the participants in the peer network. The company builds the infrastructures or marketplaces for the peer network, grow the participants as many as possible, and earn profits at scale.

Transaction. There are 5 common types of transaction processing: credit cards, banking, logistics (fulfillment), telephony and platform distribution fees (Apple store). It is all about scale.

Licensing. Software licensing is outdated. IP licensing is old and does not take advantage of scalability on internet. Open source licensing is probably cool.

Data. There are two categories of the data businesses: one that aggregates and publishes data, the other that produces its own data.

Mobile. Sell apps. Run ads on apps. Auto payments.

Gaming. Sell games. Run ads in games. Sell virtual goods in games.

To be continued.

These notes are based on the original contents from Fred Wilson’s MBA Mondays series on his AVC blog. I would like to recommend his blog to anyone who is interested in VC, entrepreneurship and business.