Entrepreneurial Death Traps, Part I: Wisdom with a Touch of Humor

[Editor’s Note:  Whether we are entrepreneurs or investors, we owe a debt of gratitude to Fred Beste, a long-time investor in early stage companies, for his insights about common entrepreneurial mistakes.  The following is a speech given a number of years ago in which he intersperses his wisdom with lots of humor.  Due to its length, the second part will be posted in a few days.  Emphasis added.]

Not long ago a friend of mine, a successful entrepreneur, was crying on my shoulder. “Fred, he said to me, “when I started my company I knew I needed a Mr. Inside, and I knew a good one, my friend George. I offered him 50% of the company. He’d have jumped just as quickly for 20%, but I liked the fairness feeling of being 50-50 partners.

Today, after five years of hard work, we’re nicely profitable on $10 million of sales. We’re pulling really good money out in salaries. We have every fringe benefit we can think of. Best of all, we’ve only scratched the surface. I can taste $25 million in sales in two to three years. At that level, we’ll be the undisputed king of the mountain in our industry, and making so much money we won’t know what to do with it.”

“Gee, Lee” I said, “I’d like to be of help, but I’m having a hard time figuring out where the problem lies.”

“It’s George” he said. “I went into his office last week and said to him, George, we need to get away from here for a couple of days and map out a new business plan designed to triple our size by 1999.”

“And what did he say” I asked.

He said, “Gee Lee, that’s nice. Right now I’ve got to leave for my golf lesson. I’ll be back by two, however, and we can talk about this. Quite frankly, though, it sounds like a helluva lot of work to me.”

“Fred”, Lee said to me, “George hasn’t been in here on a weekend in almost a year. He’s never in before 8:00 A.M. anymore and never here after 5:30. We’re losing momentum and I can’t carry this company by myself. He doesn’t want to risk the investment that would be required to pull the thing off. And being exactly a one-half owner of the company, he can and does veto anything he wants. I’m going absolutely nuts.”

I didn’t have a good answer for him. As I was driving to a board meeting right afterwards though, I thought to myself, I’ll bet that that’s the tenth time in my career that I’ve heard this 50-50 partnership tale of woe. Why do such otherwise smart people keep doing this to themselves? After no more than an instant’s reflection, I knew the answer. Because they’ve never been there before. Because “equal partners” seems so human-naturally fair. Boy, what a beguiling trap, even deathtrap, this has been for countless entrepreneurs, I thought.

But wait, I reflected, there’s more! What about the three (or four) (or five) musketeer’s death trap. Although in one sense it’s a corollary of the 50-50 partnership deathtrap, in some ways it’s even more insidious. You know the story. Three friends decide to start a company. They split the ownership absolutely equally, they draw identical salaries, they’re going to make decisions “by consensus.” It’s the logical, “fair” thing to do. One of them (perhaps the oldest or the one whose idea it was originally) reluctantly assumes the presidency because state law requires there to be one.

What a recipe for failure! There are three primary problems with this set-up. First, this company has no leader, no one ultimately responsible for its success or failure. Second, sooner or later a major, honest difference of opinions will arise. What do they do then? Third, the reluctant president will almost inevitably come to see himself as “a little more than equal.” If they have any success, for example, and get written up in the local or trade press, guess whose picture the reporter will want? Guess whose quotes will be plastered all through the story? Guess which other two people are going to hang the article on their family room dart board?

The solution? Pick a CEO and treat him like one. Give him the largest equity position and salary, even if they are only symbolically larger. Somebody has to sit where the buck stops.

By now I was on a roll. There was a cardboard box lying on the passenger seat of my car. I flipped it over to reveal its blank bottom and started scribbling notes relating to other deathtraps all over it. By the time I reached my destination, it was covered up. I counted them. There were exactly 25. Wow, I thought. I could turn this into a speech and get invitations to deliver it! ……And the rest, as they say, is history.

Sadly, so are thousands of otherwise good little companies history. Entrepreneurs face all kinds of potential adversity — some kinds can kill them, some kinds merely set them back a little. Some kinds are unpredictable, others much more so. The saddest failures that I have witnessed are the conceivably predictable, lethal ones, the ones that could and should have been avoided.

As senseless as small business deaths are which fall prey to the many-times-tripped death traps, they can be damnably difficult to avoid. Many of them appear in the form of beautiful, well-worn paths which logic, greed and even common sense might suggest taking. How tragic that they take entrepreneurs over cliffs time and time again.

To compound the challenge of avoiding such a demise, none of these paths is assuredly fatal. The important point is that they can be, and have been for many others. Each should be avoided or tempered if at all possible.

We’ve already covered two, the 50-50 partnership deathtrap and the three musketeers’ deathtrap. Although I have put the lot of them in no particular order, the third is potentially the ugliest, because when it strikes, it is only after a long run of euphoric success. For lack of a better term, I call it the One or Two Customer Overreliance deathtrap.

Let’s say that you own a small, young machine shop. You’re limping along, hand-to-mouth, at about $50,000 of sales/month. Then one day you get a call from a buyer at the largest industrial company in the county. He’s in a jam. He needs $100,000 worth of aluminum housings in two weeks and his regular vendors are backed up for a month of Sundays. You meet with your four machinists. You know you’re crazy but you take the job. You man a milling machine yourself and the five of you work ’round the clock and deliver the last of the housings at 7:00 A.M. on the deadline date. You’ve saved the guy’s bacon. He’s appreciative. Two years later you’re doing $5 million in sales, $4 million of it from this one customer. You’re personally pulling $300,000/year out of the company and there’s enough left over to fund your working capital needs. Your bank is only too happy to finance your new equipment needs and your new, expanded building. (Back in the old days when you were a banker’s pariah, you had to buy your original equipment used, out of your savings).

What do you think this guy’s thinking? That this is risky? Hell, no! I’ll tell you what he’s thinking! He’s thinking he’s a genius, a role model, the envy of his friends. He’s thinking that his major customer is damned lucky to have found him. In fact, he’s thinking that their continued success is due in no small part to his talent and hard work

I mean, is this an accident waiting to happen or what? How many times in situations like this has such a buyer ultimately called and said something like, “Gee, Bob, ‘fraid I’ve got a bit of bad news. As you probably knew (he didn’t), our union contract has a no-layoff clause, and what with the recession and all, we’ve re-assigned 60 employees to our machine shop. We’re bringing all of our machine shop work back in-house.”

Bam! In one fell stroke this guy’s running a million dollar company with a $3 million break-even.

Now, I am not necessarily suggesting that this poor slob should have turned any of this juicy business down. What I am suggesting is that he should have been working like mad to build the rest of his business, and thereby reduce his dependence on this customer. What I am suggesting is that in situations like this he should have been renting used equipment, not borrowing for new, etc., etc.

How could he have been so dumb?! Simple. It surely didn’t feel threatening to him while it was happening, and he had never passed that way before.

Picking up the pace a bit, here are the remaining 22.

4. “Mousetrap” Teams

A handful of brilliant scientists or engineers disappear into a basement and emerge six months later with an absolutely gee-whiz prototype that by all rights should run circles around the competition in the marketplace.

They have, in short, invented a “better mousetrap”. The world, though, to their great frustration and confusion, does not beat a path to their door.

This should not be a surprise – no one on this team has ever commercialized technology before. Doing this well is every bit as difficult and specialized as coming up with the product itself. It is absolutely critical that this talent be found in at least one key member of the team, and preferably the CEO.

5. Inadequate Pricing

In my friend Bill Stolze’s marvelous book Start-Up, he notes that “there is no start-up strategy more likely to fail than one predicated on being the lowest price competitor.” Adopting such a strategy is roughly equivalent to Luxembourg insisting on settling a dispute with the U.S. with ICBM’s. I would add that the statement which causes me to lose my last meal the quickest (always accompanied by big smiles, no less) is: “We’re going to have the best product at the lowest price!”

The message: Price to market. Gross margin is your best friend. It can absorb all manner of adversity with two exceptions: philanthropy or pricing stupidity (actually, in this case, the two are synonymous).

6. Insufficient start-up capital

Let’s give our hypothetical founders credit and assume that they prepared a cash flow projection before their launch. History shows that 90% of the time, first year sales and gross margin do not reach expectations for whatever perverse, Murphyish reason. Both affect cash needs negatively. If each founder originally chipped in the limit of his second mortgage potential, it might already be time for the fat lady to sing.

Don’t start a company if you cannot assuredly come up with more capital than you think you’ll need. It’s almost certain that you’ll have to.    [More to follow in a few days.  Editor]

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