Undoubtedly, the most exciting stage for many people and completely nerve-wrecking for others.

Every startup is different, and it would be arrogant to assume otherwise.  The advice we have is hard-earned, and completely free, and something we wish someone had told us long ago!

Many software companies are started by someone who works for an existing (non-software company) and sees an unfilled need which their current company isn’t going to solve. This is the “aha moment” that many founders have, and which leads them to start a company. The key piece of advice we have, at this stage, is for the founder to seriously consider the nature of their market and users. As startups begin to develop their early prototypes and a minimal viable product, it is extremely tempting to believe (we have been there!) as founder you have the right answers. Reality is that every day thousands of companies are started, and many may have a more or less similar idea. For that reason, it is important to truly understand the difference between your idea, and a market of (more or less) equal clients who have more or less the same need for your product. Why do we say this? It’s because too many products are built that fail the test of  repeatable customers. Software is quite expensive to build, but what is much more expensive is take software to market and scale up adoption. Long before you can do that, you need to make sure you understand enough of the market so that you can identify repeat customers. Harvard Business Schools has excellent webinars on this topic – and they do an excellent job of highlighting the need for the MVP to target a specific market of similar clients who want to license and use the MVP for the same reasons. In detail understand why and how they value the few, key features of your MVP.

This avoids the “if you build it they will come” fallacy, because that is rarely the case. Beyond that – don’t stop believing in your idea, just expect many iterations and calibrations as you continue to work with clients. 

Oh, and one more piece of early-stage advice. A feature (or capability) is not a company. That seems obvious, so why mention it? In some cases, we have seen innovators struggle with this. A feature, however genial, may be hard to turn into a company. This is worth thinking about, because it is usually true. 

OPEN-SOURCE

Open-source strategies are both compelling and challenging. The compelling part of an open-source strategy is that it enables a small group of developers to build an initial product, and if the product stands out and gets early adopters, the product can achieve further and potentially very rapid adoption through “osmosis” aka word of mouth.  This is truly compelling, and a great testament to the success of the open-source community. The challenges are many, and to quite a degree quite manageable. 

The advice the authors provided earlier was to think long and hard about the required commonality between MVP users in order to achieve repeat sales. How does that advice hold up in a FOSS context? It is tempting to think of FOSS as a greenfield experiment – a way to see what features that the most sought after, and drives usage, and direct effort accordingly. After all, GitHub is highly transparent in that way. In practice, this is not always easy. It requires a conscious plan and considerable effort to build a community around a product, and to build a proper “feedback loop” with users. 

So, long before more hands are needed to support the product and users, it becomes critical to establish a sustainable business model. There are many options (and too many to discuss here), but a key criteria is that the business model has to be sustainable. Many excellent open-source initiatives have failed that acid test.

MVP AND EARLY ADOPTERS

Few things are as exciting as the initial release(s) of an MVP, and the work to secure a reasonable number of early adopters. 

As the authors reflected over in the previous chapter, the decisions of which early adopters to take on is tremendously important because those early adopters will end up dictating a considerable part of the company’s direction for a considerable time. Having the wrong set of early adopters can be detrimental. Why stress this again. The whole point of the MVP and early adopter stage is to understand the product-market-fit well enough to understand how to move to the next phase. And most companies actually fail at this point. They may not go out of business, but they may secure just enough early adopters that they are able to get by financially.  This is why our introduction read that “growth isn’t the only answer”. The founders may find themselves perfectly content with the position they have achieved, supporting a limited number of clients, but they need to continuously evaluate the risk of being replaced. Software never stands still.

WHAT TO EXPECT

PEOPLE

This can’t be said enough, because it is almost always underestimated. Everyone who has built and grown companies (or worse, had to downsize a company!) knows that the company lives and dies with its people. It just means different things at different stages in the company’s life.

In the early stages, the founders and limited management team may be the only assets that make up the company. They all depend 100% on each other, and any sand in the machinery can create an enormous amount of friction and kill the potential of the company. (This is actually not entirely uncommon, and the shareholder agreement should handle some of that, but that’s for another chapter.)

As the company grows, the company needs to be able to attract new talent that complements (and sometimes replaces) the existing talent. What got you to A may not be what gets you to BHG (big hairy goal). This is not a bad thing, at all, but it’s important that owners & management recognize this, and that the individuals are willing and able to take on more and more responsibility, or let other, more capable people take that on. The authors have been in this situation many times (also when we started Papillon), and the one piece of advice we have is: Know what drives your fellow founders and colleagues, what their personal goals are, and understand the extent of their strengths and loyalty to the vision of the company. It’s easy to say, but hard to do. If you do, you can build a team dynamics which is really hard to match, and more than anything it’s relentless execution that makes a company succeed!

Remember this: It is almost never technology that constrains the potential growth of a company. It is almost always market, timing and people. The right people can to a large degree make the right decisions in light of market and timing and spending.

CASH IS KING – WORKING CAPITAL & FUNDING

It’s often said that “sales solves all problems”, and there’s a lot of truth in that, but sales almost always create the need for cash for the business to grow. As companies grow, they generally become more capital intensive. Yes, you may generate more sales, but the support, the infrastructure & cloud costs and administrative costs will invariably increase in a manner which rarely is in lock-step with the increase in cashflow. This usually means that companies will need to increase their working capital, how much money that is available at any point in time between money flowing in and out. This absolutely used to be the case prior to SaaS (e.g. perpetual + maintenance). SaaS or data sales businesses usually face similar challenges as they grow. Modelling cash-flow scenarios is critical. There are excellent SaaS spreadsheets to help with that.

Once the capital needs have been modelled, there are of course different ways to access capital. Debt financing means that owners don’t have to give up ownership, and is often favoured when the stock markets aren’t doing too well. Bear in mind that institutions that offer debt financing usually employ strict legal language to cover their risk and current owners have to put up collateral. This needs to be understood in painstaking details by the current owners and management. The authors are well aware of examples where the debt institutions have walked away with the best assets of a company after failing to meet entirely insignificant payments.

Raising equity funding comes with similar warnings. The financial institution (venture or PE) will invariably want to apply professional corporate governance. This is a good thing. Many or most funds require share purchase agreements (SPA) to include language where they control when and whether the company can raise further capital. The authors are well aware of cases when investors have used this power in ways that destroy significant value for one company in order to create value with another investment of theirs. Some of the professional investors have open-sourced their deal terms, which is an excellent way to avoid lengthy costly legal squabbles that amount to nothing by the end of the day, but current owners & management need to be comfortable with the deal terms regardless of whether they are open-sourced or not.

ACQUISITIONS

For many companies and owners, exits work out really well. Professional investors often attempt to take a balanced approach, but sellers should know that you mostly hear about the amazing deals, and rarely hear about the deals that didn’t work out. It’s just human nature to be much more open about the former than the latter.

Great deals have a few things in common: Investors take a long-term view of the business they acquire, study it carefully before acquisition, build excellent integration & post-acquisition plans during acquisition, and work hard to ensure success for the people involved.

Poor deals also have a few things in common: Buyers usually buy many more companies than sellers ever sell in their life. This puts sellers at a huge disadvantage because they are not as experienced as the buyers in evaluating the terms of the deal they are offered. This is especially crucial when it comes to earn-outs. The worst earn-outs we see are modelled to appear to be easily achievable by the sellers, but are in effect carefully constructed by the buyers such that sellers rarely will receive their earn-outs. And in many cases, earn-outs account for a large part of the value of the transaction. This is highly unethical. Another example the authors often see are deals where the sellers appear to take part in the upside that they will generate for the buyers, but don’t. This is more tricky to explain, but this often comes down to legal constructs that are not obvious to the seller at the time of the deal.

Buyers may very well argue that they take on a considerable amount of risk (when they acquire a company), and that this justifies their deal terms. The authors may very well argue the opposite – it’s the job of the buyer to get to know the company or asset they acquire, the market they are in (or enter), the deep skillset of the management team and key technical staff, and so forth. Nobody is forcing the buyer to buyer, and in most cases, sellers have a far weaker position than buyers to ascertain deal terms and the appropriate deal value. The sellers job is to be honest at all times, and present and represent their business in the most ethical way they can. That’s it. The rest is on the buyer.

KEEPING THE SKELETONS OUT

This is really just sound advice, but having been through due-diligence from all sides of the table, it’s clear that this isn’t common knowledge.

DATA-ROOM

A data-room is really just a neatly organized folder of every business document, financial, legal, HR and so forth that has ever been issued, received or signed by the company. In addition, we always recommend that companies maintain a document which describes what to find where in the folder structure. This makes it much easier for any future investors or acquirer to carry out due diligence in an efficient and cost-effective manner.  Some key points where we have spent unnecessary hours or even turned down deals:

1. Be extremely diligent about shareholdings. Carefully document any and all changes to the shareholder structure (called a “cap table”). Every cap table needs to add up to 100%.  Always. Any deals made (“Joe can buy stock from Peter”) need to be available for review.
2. Debt. It is not uncommon to carry some element of debt. Very many companies have been built with loans from friends, family, financial institutions. The terms of this debt need to be 100% clear, and be on the balance sheet. The authors have seen numerous examples of companies that have failed to record liabilities on their balance sheet for different reasons.
3. Cash. The following statement may seem silly, but authors have seen many examples where the shareholders and management treated the company’s bank account like it was their personal wallet. In one due-diligence we found that the company paid all costs for an airplane, which belonged to the CEO and founder, but which was never used in the business. Needless to say, these things will always be discovered.
4. Company tax, employee tax, VAT. This is an area which investors spend considerable time and cost to review in painstaking detail, especially whenever companies operate in multiple markets and tax jurisdiction. Management who operates the company may feel sure that things are all fine & dandy, but investors will need absolute proof of this.
5. HR-related. This is an area which is hugely different across different jurisdictions (e.g. US to Europe, but also in different European countries). Management needs to make sure they use relevant tools to maintain employee records, and in European countries this also falls under GDPR laws. We have seen companies entirely unable to locate employee contracts for their key employees, which makes due diligence very hard for investors.
6. IP. This is worthy of a chapter by itself, but the IP part boils down to a single paragraph: Does the company own, or have legal rights to everything they sell? The answer needs to be an absolute, 100% yes. No amount of “half pregnant” will do here. What specifically to avoid: Make certain that any and all 3^rd party libraries follow licenses that are commercially viable. This generally excludes GPL-alike licenses. Instead investors prefer MIT style licenses. Our advice is to maintain a list of which libraries that are in use at all times, and make sure the license is known. Most software is licensed (to clients) on terms that indemnify clients if the software is found to be in breach of patents or 3^rd party IP. This is also an area investors will want to understand. 

DUE DILIGENCE

The extent of due diligence varies with the size of the deal and the complexity of the business. The fastest due diligences are done in a few days, but on average a due diligence takes from 2 weeks to a full month when carried out by a professional and external due diligence team. Every DD team will find something and this is expected by the buyer or investor, but the management and current owners should do everything in their power (from day 0!) to ensure that no skeletons exist, because if there are skeletons, investors will invariably either walk away from the deal or demand to reduce the value of the deal considerably to account for the risk.

With that out of the way, due diligence is just a time-consuming task which unfortunately requires a LOT of time from current management and staff. For those that have not been through due-diligence, bear in mind that during these weeks, you are expected to continue to run the business, meet with clients, do the deals – and also be available at all times to assist with any questions or issues that come up during due diligence. This is hard.

Papillon’s due diligence is generally quite targeted yet light, and to the extent possible, carried out by Papillon’s management and internal team. This has many benefits for both parties – the most important one is that both parties get to know each other very well during due diligence, which is important, because all going well, both parties soon become one party with the same shared goal.