Note: This is a remix of The Path To Disaster: A Startup Is Not A Small Version of A Big Company, a blog post I wrote for publication at Tekedia on August 20, 2012. This remix is based on my experience meeting early stage startup founders in NYC since then.

Each time I hold office hours in New York City, I encounter at least one individual who comes by to ask me a version of the question: “Where do I start?”

Some are first-time founders just getting started, others are in the midst of making a transition from being employed at a company to striking out to start something on their own, or with one or two other people. In every case so far I would not characterize any of the people who have asked me this question as completely clueless, in the sense that they have a network that includes many early stage investors – angels, and venture capitalists, and they know other people who are startup founders, they read numerous blogs etc.. They have asked this question of others . . . . . and yet when they encounter me at office hours they say they still feel confused.

I always promise that they will leave with a framework that they will always be able to use as a guide. This post outlines the conversation we have.¹

I like to start with a few definitions, because that ensures that we are on the same page and thinking about things in the same way.

Definition #1: What is a Project? A Project is an undertaking by an individual or a group of individuals in order to accomplish a specific goal.

Definition #2: What is a Startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.²

Definition #3: What is a Company? A company is a business organization that has been built for the specific purpose of scaling a repeatable, and scalable business model.

Given those definitions, let’s revisit the question I get asked by first-time founders; “Where do I start?”

Inflection Point 1: Idea -> Project

Initially, an individual, perhaps two or three individuals who know one another discuss an idea and feel that they may be onto something that could become big. At that point they have a project, and their goal is to determine if their idea is a big enough one to merit devoting more resources to transforming into a physical thing. This could happen while they are still in school, or perhaps while they are employed. So work on the project occurs at night, during weekends, and in whatever free time they can find. Importantly, the project is not yet a top priority. During this stage the founder or founders will be bootstrapping, spending their personal capital in order to conduct whatever research they feel they need to perform in order to make some progress.

If they eventually conclude that the idea has enough merit to become a business one day, and they would like to pursue building that business, then they begin the transition from working on a project to forming a startup.³

Inflection Point 2: Project -> Startup

Once they make the choice to become a startup, it is most likely that the team will need to devote additional resources to their endeavor. For example; the team needs to start building a  product – a minimum viable product, someone has to start thinking about how to win early customers/users, and more time has to be devoted to sorting out a number of other issues like how everything that needs to get done at this stage will be paid for.

Friends & Family

If everything is going well so far, the founders might decide that they need some external capital. At this stage the easiest source of capital is the founders’ friends and family and the amount of capital raised will generally be less than $1,000,000. This round of capital should be devoted to building a minimum viable product (MVP) and confirming the hypotheses that the founders started to examine when  this undertaking was “merely” a project.

The key point here is that people in this group know the founders personally and are making an investment largely on the basis of their trust and belief in the founders. Often the investors in this category do not understand much about what the founders are building if the product involves a technological innovation. However, they likely believe “Brit is smart and hardworking. We know she will do great. We want to support her build her dream.” So while a financial return would be nice, it is not the primary motivation. Nonetheless, I advise founders to make it a habit to pitch the idea formally even to this group of potential investors because it is worth the effort to start learning to pitch other people even at that early stage.

This round will probably be a convertible debt round, with terms driven by the founders.

The minimum viable product is the smallest, least expensive product that can be built in order to test the most important hypothesis on which the startup’s business model will depend.

– Paraphrasing Teresa Torres

Angel Investors

If things go well enough, the founders decide that they need to raise even more capital, more than they can expect to raise from their immediate social circles. There are still important questions that remain to be answered. The business model has not yet been discovered. Although early customers/users have been identified there is not yet any meaningful revenue traction. It may be a few more months before the product is mature enough to generate meaningful revenues although potential customers/users are testing the product and so far the key performance indicators (KPIs) look promising. There is still substantial work to be done on product features, but there is enough for some early customers to consider paying for.

An angel round will generally be about $1,000,000 or slightly more, but generally less than $2,000,000 or so. With each angel investor typically investing an amount between $25,000 – $100,000 or so.

This round will probably be a convertible debt round, whose terms will be driven by a lead angel who will do some work on behalf of the group. If the round is raised from an organized angel investor network, then the process might unfold according to the framework within which the group operates.

Angels will generally have a much more sophisticated understanding of the product and the market than individuals who invested in the Friends & Family round.

Seed Stage Venture Capitalists

Two important differences between Angel Investors and Seed Stage Venture Capitalists is that Angel Investors typically do not invest on a full-time basis, and Angel Investors typically are making investments on their own behalf.

If things go well, it gets to a point where the team working on the startup has key members in place, the product has advanced beyond the MVP, there is meaningful customer/user traction, and revenue is early but indicative of a significant market opportunity. The team now decides that it makes sense to raise venture capital.

A seed stage venture fund will likely invest between $150,000 – $1,000,000 at a time, in financing rounds that range from $1,000,000 – $3,000,000 or so, but generally less than $5,000,000. Some funds might have requirements such as:

1. Minimum investment size, of say $500,000.
2. Ownership targets, of say 10%.
3. Syndicate composition, preferring a syndicate that includes at least one or two other institutional seed-stage venture capital funds.

This round will likely be a priced round, and the venture fund leading the round will set the valuation, agree to a term sheet with the startup, and negotiate the final documents that will govern that round of financing.

Here are a few nuances about this segment of the startup and venture capital ecosystem.

1. Founders should focus their efforts on finding and speaking with funds that have a current fund size that fits the size of the round the founders are trying to raise. What does that mean? A seed stage VC investing a $50,000,000 fund will likely set a minimum investment size of $500,000 or more as an internal rule of thumb.⁴ I would not spend my time pursuing a meeting with this VC if I were a founder raising a $750,000 round, for example. Why? Minimum investment size and syndicate composition would likely pose stumbling blocks. On the other hand, a seed stage VC investing from a $10,000,000 fund might be worth the time and effort I put into getting a meeting because such a fund has likely set a minimum investment amount that is less than $500,000 – say, $350,000, and may also be willing to invest as part of a syndicate that is largely filled by angels. So my $750,000 round could be filled as follows: $350,000 from a lead investor (institutional VC #1), $200,000 from another VC (institutional VC #2), $100,000 from an angel investor (angel investor #1), $50,000 from another angel investor (angel investor #2) and the remainder in $25,000 increments (from angel investors #3 and #4)
2. I do not advocate completely ignoring investment professionals at larger seed-stage funds. Let’s go back to the example of a founder raising $750,000. Assume that angel investor #4 is friends with a VC at a $120,000,000 seed stage fund and offers to make an introduction because ” . . . this is the sort of stuff they love to invest in . . . ” Then that meeting is very much worth taking because it enables the founder to start building a relationship with that VC and determine if there’s an investment and personality fit, and it enables the VC to observe the progress the startup is making over time and to get a more intimate sense of the founders’ management decision-making skills. This matters because this VC could be a potential investor in a subsequent “Institutional Seed Round” in which the startup is raising $2,500,000 for example.

Inflection Point 3: Startup -> Company

If things are going well, our startup gets to the point where it now wants to raise more than $5,000,000 because the founders believe they have:

1. Confirmed their primary hypotheses,
2. Understand how to win customers/users, and how to generate revenues and profits,
3. Need more capital to pursue sales, and
4. Hire more people.

This organization is still a startup, but it has started the slow transition from being a startup to becoming a company. This transition will depend to a large extent on how successful the startup is at creating and satisfying demand for its product. This transition will probably traverse several rounds. Generally I think of Series A, B, C and D as covering the period during which a startup is building out the internal and external structures that help it become a company. How do you know a startup has become a company. Well, it starts resembling organizations to which we are often accustomed. The existence of a full complement of c-suite executives is one good indicator.

Ultimately we get to a point where, the search and discovery stage has receded far into the past, and the structures of a company have been built. All that is then left is for the company to grow by executing and scaling the business model, and generating profits.

In Sam Altman’s article “Projects and Companies” he points out that the distinction is important mainly because of how it affects the way founders behave and think about what they are doing. The underlying feature of the transition from an idea to a company is that founders should be in a learning, experimentation, and discovery mode.

Distinctions matter. There is an important difference between a startup and a company.

In a company customers are already known, the product features that matter to these customers is already known, how much they will pay for the new product or service has already been established, and the market opportunity has already been sized and is well understood. In a company the business model is already known, and most activities are designed to execute a detailed business plan.

In contrast, a startup begins with no customers, no real understanding of the features customers need, no idea what customers will be willing to pay for the product, and no knowledge of the business model that will be most suited to creating, delivering and extracting value.

Steve Blank and Bob Dorf describe The 9 Deadly Sins of The New Product Introduction Model in their book The Startup Owner’s Manual.⁵ These are the lessons they offer startup founders who are in the search and discover phase.

1. Don’t assume you know what the customer wants – start with guesses and hypotheses. These become facts only after they have been validated with customers willing to pay for the product.
2. Don’t assume you know what features to build – this follows directly from the preceding lesson, avoid building features no body cares about by first testing your assumptions about them with customers willing to pay for them.
3. Don’t focus on a launch date – instead focus on building a product that customers want to pay to use. Focusing on a launch date can cause the team to place an emphasis on the wrong things, causing the startup to hurtle towards the launch date even if it does not yet know its customers, or how to educate them about its product. Also, this becomes a milestone by which the startup’s investors will judge the performance of their investment.
4. Don’t emphasize execution. Rather emphasize developing and testing hypotheses, learning, and iteration – the emphasis on getting things done at a startup can lead employees to focus on execution rather than searching for answers to the guesses that the startup is operating under. Hypotheses have to be tested, and tested again. Executing on untested hypotheses is a “going-out-of-business strategy.”
5. Don’t focus on a business plan, instead search for a business model – A business plan offers the great comfort of presumed certainty. The reality of a startup’s existence is one of acute uncertainty. That can be very unsettling. A startup’s founders, investors, employees, and board of directors must avoid the seduction that accompanies reliance on business plans, and the management tools that characterize the experience of large companies with known customers and well-established business models. Results of experimentation and validation tests should matter more than milestones.
6. Don’t confuse traditional job titles with what a startup needs to accomplish – the traits that an individual needs in order to succeed in the environment of a startup differ significantly from those that lead to success in a large company with a known business model, a fixed business plan, known customers, and a known market. In contrast, to succeed in the startup environment an individual needs to be comfortable with chaos, flux, and “operating without a map”. The worst thing that could happen for a startup is for employees to default to behaving as they would if they were working in a large company.
7. Do not execute a “Sales and Marketing” plan too early – sales and marketing can become too focused on executing to a seemingly great plan rather than learning the identity of a startup’s most profitable customers and gaining knowledge about what will spur those customers to engage in behavior that enables the startup generate revenues and profits. Consider a scenario in which a startup has gained hundreds of customers but only a tiny fraction of those customers actually make a purchase, and to make things worse a vast majority of completed purchases are made by a an even smaller number of repeat buyers. A focus on the “number of customers” might camouflage the startup’s dire need to determine what steps it needs to take in order to dramatically increase the number of paying customers.
8. Don’t presume success prematurely – executing to a business plan often leads to premature scaling, even when the reality might call for the startup to hit the brakes. Expanding overhead costs before the revenue to support such costs materializes is the shortest path to disaster for a startup. Hiring, and infrastructure expansion should only happen after sales and marketing have become predictable, repeatable, and scalable processes. Moreover, startups need to be impatient for profits but patient for growth. A startup that know’s how to earn a profit can survive indefinitely.1 A startup that does not know how to earn a profit, but instead is focused on other measures of growth is playing a dangerous game of Russian roulette.
9. Don’t manage by crises, that leads to a death spiral – the accumulation of all these mistakes leads to the inevitable demise of the startup that makes the mistake of operating as if it is merely a small version of a big company.

For those potential first-time founders who are grappling with the question: “Where do I start?” . . . I hope this helps.

Next? I think you should read: Paul Graham – Default Alive Or Default Dead?

 

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1. Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it. ?
2. I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. ?
3. Sam Altman discusses the distinction between a project and a company in “Projects and Companies” which might be worth reading. ?
4. This is a general rule of thumb. Clearly, a fund like 500 Startups will have a different rule. ?
5. Steve Blank and Bob Dorf, The Startup Owner’s Manual Vol. 1: The Step –by-step Guide for Building a Great Company, Pub. March 2012 by K and S Ranch Publishing Division. ?

This is the third post in my series of blog posts on economic moats. I have already written about Network Effects and Switching Costs. The remaining three sources of an economic moat are Cost Advantages, Efficient Scale, and Intangibles.¹

In writing this post I am trying to consolidate what I have learned about intangibles & startups for myself.

I also hope that it is useful for first-time seed-stage technology startup founders who are trying to build a product, achieve product-market fit, and raise financing from venture capitalists. Often such founders are trying to accomplish all that while they also try to learn strategy, management and other subjects they perhaps had not been exposed to before they decided to build a startup. My goal in that sense is to provide one example of how an early stage venture capitalist might be thinking about these issues while assessing startups for a potential investment.

To ensure we are on the same page, I’ll start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups. If you by-chance have read the preceding posts in this series, you would have seen some of these definitions already.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.²

A company is what a startup becomes once it has successfully navigated the discovery phase of its lifecycle. As an early stage investor one of my responsibilities is to assist the startups in which I am an investor to successfully make the journey from being a startup to becoming a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition.

That definition of a moat is the one provided by Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: The Morningstar Approach To Stock Investing.

I take things a step further in thinking about startups and companies with business models that rely on technology and innovation. I think of a good moat as performing at least two functions; first, it provides a structural barrier that protects a company from competition. Second, it is an inbuilt feature of a company’s business model that enhances and strengthens its competitive position over time.

As a result I have arrived at the following definition of an economic moat pertaining specifically to early stage technology startups;

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

Definition #3: What are Intangible Assets? An asset is a resource that is owned by a startup with the expectation that it will provide an economic benefit to the startup in the future. Intangible Assets are assets that are not physical in nature; intellectual property, brands, skill in research and development, regulatory environment, culture and management.

Baruch Lev explains why intangibles matter:

Intangible assets—a skilled workforce, patents and know-how, software, strong customer relationships, brands, unique organizational designs and processes, and the like—generate most of corporate growth and shareholder value. They account for well over half the market capitalization of public companies. They absorb a trillion dollars of corporate investment funds every year. In fact, these “soft” assets are what give today’s companies their hard competitive edge.

– Baruch Lev, Sharpening The Intangibles Edge, Harvard Business Review June 2004 Issue ¹

In the remainder of this post I will discuss each broad category of intangibles from the perspective of an early stage startup and the issues such a startup’s founders ought to be aware of.

Intellectual Property

Bottom line: All things equal, a startup with a sophisticated understanding of the role that IP plays in creating value for customers and shareholders will be more attractive to shareholders than its peers.

According to the World Intellectual Property Organization: “Intellectual property (IP) refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce.” As far as early stage technology startups are concerned I am mostly interested in copyrights, trademarks, patents, and trade secrets.

I am not an IP attorney, so please consult an IP attorney if you read this and have specific questions about how to protect your startups IP. The goal of this discussion is not to examine the intricate legal details and nuances of IP law, but rather to offer a broad view of the IP landscape with pointers about some of the issues to which first-time founders should pay attention.

Copyrights: This is a form of protection that is granted to the original author of any piece of work that can be stored in some form of fixed media. A copyright protects the original author’s work from indiscriminate copying by other people. Among other things, copyrights protect computer software, computer programs, blog posts, advertisements, marketing materials, videos, pictures etc etc. Merely creating the work in a form of fixed media establishes the copyright. In other words, an algorithm that exists in my mind is not protected by a copyright, but my copyright comes into existence the moment I commit it to software or document it some other tangible way – for example, in a notebook.  While it is not necessary to register the copyright in order for the right to exist, there is a benefit to copyright registration with the appropriate legal jurisdiction. In the United States, a copyright holder can not file a lawsuit for infringement if the copyright is not registered with the United States Copyright Office.

It is important for early stage startup founders who rely on outside vendors and other contractors to understand the “work for hire doctrine” and its implications on copyright ownership. According to the United States Copyright Office: “If a work is made for hire, an employer is considered the author even if an employee actually created the work. The employer can be a firm, an organization, or an individual” The parameters for determining who is an employee is not very straightforward in an environment within which the early stage startup; exerts little or no control over the how the work is done, exerts little or no control over the employee’s work schedule over the duration of the contract, or does not provide the employee with benefits or withhold income taxes from the employee’s pay. Due to these ambiguities, I think that early stage startup founders should make it a practice to protect some of the work done by contractors and vendors with work for hire agreements. A good work for hire agreement will state unambiguously that the work product covered by the agreement between the startup and the contractor is a work for hire to the benefit of the startup.

For  an individual, copyrights extend for the life of the original author and for an additional 70 years beyond the author’s death. For a startup, the copyright extends for 120 years from the date of creation or 95 years from the date of publication.

Trademarks: According to the US Patent and Trademark Office “A trademark is a brand name. A trademark or service mark includes any word, name, symbol, device, or any combination, used or intended to be used to identify and distinguish the goods/services of one seller or provider from those of others, and to indicate the source of the goods/services.”

Establishing a trademark is an important part of how an early stage startup begins to communicate its brand with its customers or users. Trademarks can take different forms, for example a distinctive sound can be used as a trademark.

Similar to copyright protection, merely using the mark in the course of doing business establishes the trademark right for the startup that owns the mark.

According to the International Trademark Association trademarks are:

1. Fanciful Marks – coined (made-up) words that have no relation to the goods being described (e.g., EXXON for petroleum products).
2. Arbitrary Marks – existing words that contribute no meaning to the goods being described (e.g., APPLE for computers).
3. Suggestive Marks – words that suggest meaning or relation but that do not describe the goods themselves (e.g., COPPERTONE for suntan lotion).
4. Descriptive Marks – marks that describe either the goods or a characteristic of the goods. Often it is very difficult to enforce trademark rights in a descriptive mark unless the mark has acquired a secondary meaning (e.g., SHOELAND for a shoe store).
5. Generic Terms – words that are the accepted and recognized description of a class of goods or services (e.g., computer software, facial tissue).

A fanciful mark has the strongest trademark protection. A generic mark has the weakest protection. Over time, the protection afforded a fanciful mark can wane if that term becomes a generic term that is used to describe a category.

A startup founder seeking trademark protection should seek the advice of an IP attorney since this is a more complicated topic than copyright protection.

Patents: According to the World Intellectual Property Organization “A patent is an exclusive right granted for an invention. In other words, a patent is an exclusive right to a product or a process that generally provides a new way of doing something, or offers a new technical solution to a problem. To get a patent, technical information about the invention must be disclosed to the public in a patent application. The patent owner may give permission to, or license, other parties to use the invention on mutually agreed terms. The owner may also sell the right to the invention to someone else, who will then become the new owner of the patent. Once a patent expires, the protection ends, and an invention enters the public domain; that is, anyone can commercially exploit the invention without infringing the patent. A patent owner has the right to decide who may – or may not – use the patented invention for the period in which the invention is protected. In other words, patent protection means that the invention cannot be commercially made, used, distributed, imported, or sold by others without the patent owner’s consent.”

A utility patent is used to protect the functional features of an invention. Most of the patent applications made to the US Patent and Trademark Office are for utility patents. A design patent is used to protect the appearance of an invention. Utility patents generally provide broader protection than design patents, also it is easier to avoid infringing on a design patent. Utility patents are more expensive to obtain and take longer to obtain.

To receive patent protection an invention must be:

1. Patentable,
2. New, or novel,
3. Useful,
4. Non-obvious, and
5. Adequately described.

Additionally, software and business process patent applications will likely be subjected to a “machine or transformation test.” The machine test means that software or business processes can not be patented unless they are combined with a machine of some sort – a computer. The transformation test means that software or business processes cannot be patented unless they transform one thing into another, different thing, or into a different state.

An invention is “adequately described” in a patent application if “someone of ordinary skill in the arts” can replicate the invention using nothing but prior background in that technical field along with the inventor’s description in the patent application.

An invention is non-obvious if someone of ordinary skill in the arts would not necessarily have reached the deductions made by the inventor on the basis of prior art in that technical field.

A theory will not receive patent protection, in and of itself it is not useful in a practical application.

There are two main patent award systems; first to invent, or first to file. In first to invent jurisdictions, the first person or group of people to conceive of an invention will be awarded patent protection if they go through the application process successfully and can demonstrate that they indeed conceived of the invention first. In a first to file jurisdiction the first person or group of people to file an application for patent protection will be awarded the patent irrespective of when they conceived of the invention relative to other inventors pursuing the same invention. The United States is a first to invent jurisdiction.

In the US, the clock starts ticking when an inventor first discloses the invention to the public – such disclosure could happen during a presentation to investors, a sales pitch to potential customers, or a presentation at an industry conference. Once public disclosure of the invention has occurred, the inventor has one year within which to file a patent application. If a year elapses without the inventor filing for patent application, that inventor then forfeits patent protection for that embodiment of the invention.

To avoid this, a provisional patent application can be filed with the USPTO to preserve a filing date. A final, or utility application has to be filed within 12 months of the provisional application. The utility application is what the USPTO examines in order to determine the merit of the inventors appeal for patent protection.

Outside the United States, inventors do not have the benefit of a grace period. As a result any international patent applications must be made as soon as possible, in order to preclude public disclosure by the inventor.

Public disclosure causes the invention to become part of the “prior art” in the field of the invention.

In 2009 I worked on an intellectual property audit with the management team at David Burke Group, that process culminated in the issuance of a patent, US 20100310736 A1 which describes a process for aging meat. The dry-aged steaks served at DBG restaurants are prepared using this process. That was my first experience securing intellectual property rights on behalf of a company.

In 2011 our team at KEC Holdings³ invented a family of financial derivatives. I assumed responsibility for (1) ensuring that our valuation methodology was justifiable on the basis of widely accepted financial and economic principles, and (2) working with an IP attorney to attempt to obtain patent protection for the idea. Our electronic documentation of the idea came to 50+ pages of background, mathematical derivations and proofs, problems and worked solutions to demonstrate how the invention might be used in practice, valuation tables etc etc.

In 2012, I worked with a team of founders in Ghana who wanted to seek a patent for their idea. I was a volunteer mentor/advisor to the team. They worked with a patent agent in India. The working relationship was ineffective for reasons that were entirely preventable if the team had embraced some simple suggestions about how to work with a patent agent/attorney working on their behalf.

What have I learned about how to work with a patent attorney or patent agent?

Generally, a patent attorney or patent agent is unlikely to be an expert in the technical field of an invention even if they specialize in the legalities of obtaining a patent in that field; a software patent attorney is unlikely to understand the nuances of a software product as well as a software engineer. For that reason, it is the inventor’s responsibility to transfer as much background knowledge as possible about the technical field of the invention and specific nuances of the invention itself to the patent agent/attorney. First, this will help the attorney perform a more complete and comprehensive patentability search. Second. it will ensure that the patent application is drafted correctly from the outset. That has the benefit of minimizing rework. Third, it will also help the attorney answer questions and respond to objections during the period when the patent is being examined by patent examiners.

Here are some additional suggestions:

1. Maintain “excruciatingly detailed” notes about the invention. You should describe the invention such that someone of considerably less expertise than you can understand the description. Also, keep pictures, drawings, figures, and any data that you create as you go through the invention process. It is a good idea to maintain a “lab-book” with numbered pages, dates, and handwritten notes about how you have tested your invention using theory, as well as the steps you have taken to test the output of what you have created. These can be supplemented by electronic notes created with MS Word, and also saved as PDF files as well as spreadsheets you have developed to test the idea further.
2. Describe of prior attempts to do what your invention does, and keep notes about why those prior attempts did not work.
3. Keep notes about the alternatives to your invention, and descriptions about how your invention is unique. You should describe the advantages of your invention over the prior art and alternative approaches.
4. Keep records about any discussions you have had about the invention with people outside of the immediate team working on your startup’s product.

Assuming it makes sense, you should discuss the possibility of obtaining international patent protection with your IP attorney. In certain instances it is possible to speed up a patent application in the founders’ home jurisdiction by first obtaining a patent abroad using the Patent Cooperation Treaty (PCT) between different jurisdictions. You should ask your attorney about this, and come up with a strategy that works given your specific circumstances.

Here’s one illustrative example:

A startup founder in the United States must decide how to protect her idea with a patent. If she files in the US it will likely take 5 years or more before the patent is granted. If she files in the UK the wait is much shorter, 2 years or less before she may expect to be granted the UK patent. What should she do? She would like to obtain patent protection in the US and the UK since she believes these are her startup’s two most important markets. She should ask her patent attorney about using the PCT and Fast Track Examination under the Patent Prosecution Highway (PPH) to speed up the process.

What is the PPH? According to the USPTO: “The Patent Prosecution Highway (PPH) speeds up the examination process for corresponding applications filed in participating intellectual property offices. Under PPH, participating patent offices have agreed that when an applicant receives a final ruling from a first patent office that at least one claim is allowed, the applicant may request fast track examination of corresponding claim(s) in a corresponding patent application that is pending in a second patent office. PPH leverages fast-track examination procedures already in place among participating patent offices to allow applicants to reach final disposition of a patent application more quickly and efficiently than standard examination processing.”

In the scenario I painted above, our founder should apply for the UK patent and then use that as the basis for requesting fast track examination of her US patent application at the appropriate time. In which case she might obtain her UK patent as well as her US patent within 24 months of filing her patent application in the UK; 18 months to get her patent granted in the UK and 6 months under PPH to get her patent granted in the US. Remember, I am not a patent attorney. Discuss this with you lawyer.

Trade Secrets: A trade secret is any confidential and non-public information that confers a competitive advantage on the owner of that information because of it is not known to the public, and especially because it is not known to competitors in that market. The owner of the information must make demonstrable effort to keep the information secret.

Trade secrecy can be lost by legitimate means, such as reverse-engineering by a competitor. Also, trade secret protection lasts for as long as the information remains confidential and undisclosed to the public. Any kind of information can be designated as a trade secret by its owner.

The key to maintaining trade secrecy is the creation of internal practices and procedures that are designed to protect the information designated as “trade secrets” from being divulged to the public.

The mystique behind the formula for Coca Cola is one famous example of a trade secret.

Trade secrets have the following advantages, among others:

1. It is cheaper to obtain IP protection through trade secrecy than by going through the process of obtaining a patent.
2. A trade secret can cover subject matter that would not qualify for patent protection, for example; mathematical formulae, algorithms etc.
3. Protection of IP through trade secrecy comes into effect almost instantaneously, and that protection can last indefinitely if appropriate processes, procedures and practices are put in place.

Trade secrets have the following disadvantages, among others:

1. As previously stated, trade secrets can be reverse engineered by others.
2. Information protected by one party (A) could legitimately be “independently invented” by another party (B) which then proceeds to seek and obtain patent protection for the invention. In that case A would be in violation of B’s rights as the patent holder. I do not understand how this works in “first-to-invent” jurisdictions, so it is worth speaking with an attorney if a choice has to be made between trade secrecy and patent protection.
3. Once trade secrecy is lost, it is lost forever.
4. Trade secrecy provides a significantly lower degree of protection than protection obtained from holding a patent.

Brand

Bottom line: To build a strong brand early stage startup founders must start by building a product that wins wide and sustained adoption by the market because the startup has intimate knowledge of its customers/users.

A startup’s brand develops primarily as its users and customers build an accumulation of experiences with its product or service over time. Ideally, these accumulated experiences should lead to customers and users having a positive affinity towards the product or service. The positive feelings that users or customers feel towards the startup and its product should be amplified through public relations, media and press commentary about the startup, community outreach, marketing, and advertising. Trademarks, copyrights, design, and iconography should all reinforce the positive emotions that the startup is accumulating within its users/customers towards itself. Lastly, knowledge that a startup has developed “trade secrets” which contribute to the pleasant experiences customers/users have each time they use the product/service can serve as a powerful source of implicit brand affinity and loyalty.

Austin McGhie puts things succinctly in his book Brand is A Four Letter Word when he defines a brand as:

1. “A brand is emotional shorthand for a wealth of accumulated or assumed information.” or
2. “A brand is present when the value of what a product, service, or personality means to its audience is greater than the value of what it does for that audience.”

According to Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: “A brand creates an economic moat around a company’s profits if it increases the customer’s willingness to pay or increases customer captivity. A moatworthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits.”

Austin McGhie emphasizes throughout his book that a company’s brand embodies the market’s response to:

1. The company’s product,
2. The customer/user’s experience when they use the product, and
3. The company’s marketing strategy, which should lead to a differentiated and valuable positioning of the company and its products relative to its competitors.

Early stage technology startup founders commonly treat marketing as an afterthought. That is a mistake. The excuse I have encountered when we discuss this topic is that there is insufficient capital for the startup to devote to marketing. The problem with that line of thinking is that it exposes a lack of imagination; marketing is not a one-size-fits-all proposition, nor does it always have to be expensive in order to be effective. Moreover, a startup’s founders are its most effective marketers in the very early days of its existence.

What should marketing look like during those early days when capital is scarce and the startup appears to lurch from one near-death experience to another? It should be a simple, uncomplicated strategy to:

Communicate to customers;

1. What – What problem does the startup’s product solve for them?
2. How – How is this better than the current alternative?
3. Why – Why should they accept the risk that comes with trying a product from an early-stage startup? Why will they gain more than they stand to lose?

One complexity that early stage technology startup founders must contend with is that marketing in technology is multifaceted in the sense that there are numerous constituencies engaging with the startup’s marketing at any given time. Prospective customers want to know if they should switch to the new product/service. Investors want to know if they should make an investment. Potential distribution partners want to determine if there is a benefit for them in forming a partnership. Employees want to get a sense of how much job-security they can expect. Technology press and bloggers want to be first to scoop the next big thing. Regulators want to make sure that consumers are protected. Oh, and don’t forget competitors too. They’ll be paying rapt attention.

Research and Development

Bottom line: Research and development should purposely seek to strengthen the startup’s ability to win and retain customers, and increase profitability.

To understand why an early stage startup founder’s attitude towards research and development (R&D) matters, we first need to understand what it is.

Paraphrasing Investopedia, R&D is:

The set of systematic, investigative, and exploratory activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or that can lead to an improvement of existing products or procedures, and in the process create better ways of solving customers’ problems, creating new profit opportunities for the business.

Notice the key elements of R&D:

1. It is systematic, investigative, and exploratory – it seeks to expand the boundaries of organizational knowhow and organizational capacity.
2. It seeks to solve customers’ problems in a better way than the status quo.
3. It seeks to create new opportunities for the startup to make profits.

For those reasons, R&D is one important means by which any organization that operates in a competitive market can create an enduring competitive advantage for itself.

There is only one valid definition of business purpose: to create a customer.

– Peter Drucker

If you agree with that definition, then it follows that activities that make a startup more likely to create and hold onto new customers must be pursued. Those activities are what we call R&D.

Research demonstrates the important role that R&D can play in investment returns:

In this paper, we examined the future excess returns of R&D intensive firms. Firms with R&D intensity measure greater than (lesser than or equal to) that of the industry are classified as Leaders (Followers). We show that Leaders have sustained future profitability. However, the future risk-adjusted excess returns are higher for Leaders than Followers, suggesting that the stock price does not incorporate the R&D relevant information in a timely fashion. We then directly examine the difference across Leaders and Followers of two risk measures: stock return volatility and future earnings variability. We find that Leaders have lower stock return volatility and earnings variability, ceteris paribus. We then examine whether the financial analysts’ help mitigate the apparent lack of information with respect to R&D, and find that even though the longterm earnings growth estimates for Leaders is high, they revise these estimates downwards perhaps as a reaction to short-term earnings. Overall, it appears that the stock market does not incorporate the Leaders’ potential for sustained future profits as argued in the strategy and economics literatures.

– Baruch Lev, Suresh Radhakrishnan, and Mustafa Ciftci. The Stock Market Valuation of R&D Leaders ²

So what does this mean for early stage investors? All else equal, invest in startup founders who show indications of being capable of building organizations that will become R&D leaders in the markets in which they have to compete.

How might one go about assessing this? How often in the past have the founders’ started with the same information as everyone one else, but examined it in a way that led to unexpected results that proved to be correct and so enabled them to exploit an opportunity others ignored or did not know existed?

Culture and Management

Bottom line: The early stage startup founders who excite me the most have convinced me that they know how to build an organization that will become exceedingly more valuable than the sum of its parts. They must inspire excellence from their co-founders, from other early team members they recruit to join the startup, and they must inspire devotion from their early customers.

Does the startup’s culture, and the assumptions that its founders make about the core assets it should acquire and how it should be structured as an organization lead to an overwhelmingly positive reaction from the market and from its customers?

One aspect of seed stage investing that I feel is not sufficiently discussed explicitly is how much of a bet seed-stage investors are taking on the founders’ decision-making skill as managers of entrepreneurial risk, and the assumptions that drive those decisions.

What are the kinds of decisions seed-stage investors are betting founders will make, and make correctly on a consistent enough basis to yield a return on the investors’ capital?

Below, I paraphrase some definitions of an entrepreneur to help highlight this idea.

Jean-Baptiste Say: An entrepreneur shifts resources out of an area of lower productivity and into another area of higher productivity and return. (1800)

Frank H. Knight: An entrepreneur is someone who confronts a business challenge and is confident enough to risk financial loss in order to overcome that challenge. (1921)

Joseph Schumpeter: An entrepreneur is someone who exploits market opportunities through technical and organizational innovation. (1965)

Peter Drucker: An entrepreneur is someone who always searches for change, responds to it and exploits it as a business opportunity. (1970)

Robert Hisrich: An entrepreneur is someone who takes the initiative to organize social and economic factors of production in order to create something unique that is of value to society, and accepts financial and social risk in the process. (1990)

In some cases, including the entrepreneurial context, uncertainty includes not only uncertainty about others’ actions, but also uncertainty regarding the courage and willingness of others to act.

– Ross B. Emmet, Frank H. Knight on the “Entrepreneur Function” in Modern Enterprise (PDF)

What are some of the decision-making pitfalls that can cause the failure of an otherwise promising seed-stage startup? I’ll list some examples I have encountered since 2010.

1. Insufficient focus on the customer, too much focus on the technological innovation.
2. Sub-par outcomes regarding recruiting great people, and empowering them to bring the founders’ vision into reality.
3. Inability to think creatively about new organizational designs and structures that will yield better insights about shifts in the expectations of existing customers, the potential pockets of potential new customers, and opportunities that might be going unrecognized by competitors.
4. Incongruities between what the startup needs to accomplish in order to satisfy its customers and achieve product-market fit, and the choices that the founders make. For example, relocating the startup and its team to a geographic region that makes it difficult to reach its most promising potential early customers and makes it difficult to recruit the people it needs.

There are many others.

One problem seed-stage investors face in trying to sort founders who go on to build successful companies from founders who fail to get past the startup phase is that it is very hard to differentiate between skill and luck at that stage because the financial ratios and metrics that one could use to make that determination do not yet exist. Managerial decision making skill only reveals itself over time.

So what is a seed-stage investor to do? Study the founders’ past accomplishments and try to determine which aspects of that track record result from decision-making skill. Isolate them from the other aspects of the founders’ past accomplishments that could be attributed to luck. Weigh those two things during the assessment of what that means for the startup. I try to provide sufficient time to observe founders’ decision-making skills and abilities before I have to make a final decision – individual skill matters just as much as collective skill. As a result I am interested in the role that each co-founder plays in the final outcome. For example, did the CTO fail to prevent the team from making an incorrect choice of the technology on which to build the product? If so, does the CTO take personal responsibility for that failing, or does the CTO attempt to pass blame and make excuses?

Culture is the way in which a group of people solves problems.

– Geert Hofstede

It is also important to remember that the culture of a startup is determined predominantly by the attitude, behavior, and personality of the founders. In trying to understand the kind of culture that will develop as an early stage startup evolves I am interested in trying to understand if the following things are true.

1. The founders are self-aware, and understand how their behavior affects the startup through the response it elicits from members of their team, from their early customers/users, and from their early investors. Example: They hire strong performers who have complementary skills, and they empower those people to excel.
2. The way the founders talk about themselves and the organization they are building is distinctive, it illuminates the founders’ beliefs about the world, and about the reality they will create as a result of those beliefs. Example: No one could confuse this startup with another startup because the distinction between the two is unambiguous.
3. The founders understand what they need to do to build a winning team. They also know why they need to do those things if they want their team to succeed. Example: They communicate clearly. They hold themselves accountable. They are adept at reducing harmful internal conflict. They promote and moderate the types of internal debate and disagreements that will help their team make better decisions. They motivate people to work hard, and in exchange offer fair reward and recognition for the hard work it takes to build the startup. They encourage experimentation, and learning from failure. They are great teachers, and great students. They bring out the best in others by inspiring great performance.
4. The founders understand that culture is not something they can ignore until things are falling apart, rather it has to be tended continually. Culture matters just as much as engineering, sales, and other organizational functions that are much easier to measure and manage. Example: They understand that an organization with a strong culture is easier to manage, and often will have a longer period of sustained excellence than an organization with a weak culture.

Culture is the collective programming of the mind which distinguishes the members of one group from another.

– Geert Hofstede

Regulatory Environment

Bottom line: If it is appropriate I want to see some evidence that founders have an understanding of the role that regulations might play; will they be a catalyst or an impediment? What can the startup do to make regulations work in favor of the business model that the startup has set out to create?

I have to admit that this is the most difficult intangible for me to discuss for a number of reasons. First, I have relatively less experience on this subject than on the preceding ones. Second, it is such a specialized subject that it is most likely a function that will largely be outsourced to a lobbyist, at least in the United States. Last, this is unlikely to be something a startup needs to worry about until it has grown considerably, which is likely to happen well beyond the seed stage.

The regulatory environment is the framework of rules, laws, and regulations that the startup and its competitors have to adhere as they go about their operations.

Startup founders who can play a role in shaping the regulatory environment that is developed to govern their activities have a better chance of influencing events in their favor than founders who demonstrate an inability to influence legislation.

In the United States there are many examples of regulators requesting comment from participants in an industry during the period when rules, laws, regulations are being crafted to govern the activities of organizations within a given market.

It’s worth observing that the benefits of this asset accrue to every entity that decides to enter that market after rules have been established by regulatory bodies. As a result, first-movers who bear the cost of creating a favorable regulatory environment might be at a relative disadvantage to other organizations that decide to enter the market after a regulatory framework has been established since the first-mover would have borne all the social, political, and financial risks of putting the regulatory environment in place. In comparison to the first-mover, fast-followers get a free-ride.

Concluding Thoughts

Assessing intangibles and their potential impact on the future of an early stage startup is hard work that can seem to rely on information that is even more qualitative and less data driven than other aspects of early-stage startup analysis. Nonetheless, it is important to think through the issues carefully since that work can lead to important conclusions that highlight potential risks, point to future areas of opportunity, and yield better decisions about when and where the investor should deploy scarce capital.

Collectively, intangibles are important because once a startup establishes them as an asset, it is impossible for that asset to be replicated in exactly the same way by a competitor.

Additional Reading

Blog Posts & Articles

1. Most Company Culture Posts Are Fluffy Bullshit – Here’s What You Actually Need To Know
2. 80% of Your Culture Is Your Founder
3. The Ultimate Guide To a Startup Company Culture
4. Netflix: Reference Guide on Our Freedom & Responsibility Culture (PDF)
5. A Summary of Peter Drucker’s Innovation and Entrepreneurship
6. Peter Drucker’s Life and Legacy – A Drucker Sampler

Books

1. Reinventing Organizations
2. Delivering Happiness
3. Work Rules
4. Setting The Table
5. Small Giants
6. Good To Great and Built to Last (See also: Was “Built To Last” Built to Last?)
7. Innovation and Entrepreneurship

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1. Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained it. ?
2. I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. ?
3. KEC Holdings is the parent company of KEC Ventures. ?