Author Archives: Karl T. Ulrich

About Karl T. Ulrich

CIBC Endowed Professor - The Wharton School. I teach, research, and practice innovation, entrepreneurship, and design.

Opportunity Identification

I’ve written a lot about opportunity identification in my books Product Design and Development, Innovation Tournaments, and The Innovation Tournament Handbook. The topic is also covered fairly extensively in the course OIDD 614 Innovation Management. Consider this chapter a quick summary of the big ideas in the context of identifying entrepreneurial opportunities.

Often the Opportunity Finds You

On my weekly podcast I have interviewed about 500 founders. For about half of these founders, the opportunity found them; they did not go looking for an opportunity. For example, consider Flava Naturals, founded by Alan Frost. Here is how he describes the origin story.

“I told you we should eat more chocolate!” I looked up from my coffee and there was my wife holding out the New York Times, and looking very happy. She’d just read an article about a Columbia University study that linked chocolate to enhanced memory. (…) But I was a biotech exec accustomed to how the media could exaggerate the importance of findings in small studies. I love chocolate too, but was skeptical, to say the least. So I dug deeper. Sure enough I found dozens of placebo-controlled studies that demonstrated meaningful benefits of cocoa flavanols on brain, heart and skin function. There was a catch though, and a pretty big one. The best results seemed to require consumption of 500-1,000mg of cocoa flavanols a day — that’s 5-10 average dark chocolate bars! (…) So began my quest to develop a decadent chocolate with the naturally preserved flavanols proven so healthy. And a business was born.”

Alan Frost, Founder and CEO Flava Naturals

Another common pattern is that entrepreneurs experience a pain point themselves and then set out to create a solution to address their own needs, and hopefully those of a larger market. Tammy Sun founded Carrot fertility services when she found that her employer did not cover fertility benefits as part of her health insurance, and that there were no enterprise solutions for managing fertility services for employees. She then set out to found a company to meet that need.

A third pattern, probably least common, is that an individual or team seeks out an entrepreneurial opportunity but has no particular problem area in mind. For example, Alan Cook founded, grew, and sold a first business in the pet care space, an opportunity born out of frustration with conventional litter boxes for cats. After a brief sabbatical, he sought to start another company, but this time was agnostic about the specific problem area. With the help of members of his previous team, he generated and considered about one hundred distinct opportunities, from pre-packaged spices to reconfigurable furniture, before focusing on another pet care product, this time for dogs. He pursued that opportunity not because he experienced a need himself — Alan doesn’t even have pets — but rather because he felt his prior experience gave him an unfair advantage, always a good thing for an entrepreneur.

A Personal Innovation Tournament

If you are motivated primarily by purpose, then the opportunity obviously matters a lot — after all you are setting out to do something specific in society. In that case, the entrepreneurial opportunity had better be aligned with that purpose. However if your goal is fun or financial return, does the selection of opportunity even matter very much? Put another way, is there not an opportunity to be financially successful or to have fun in pretty much any area of the economy? Sure, to some extent, you as an entrepreneur can probably find a viable opportunity almost anywhere you look. However, you will likely spend at least five years of your life pursuing a new venture. You might as well be quite deliberate about which opportunity you pursue. In my opinion, a good rule of thumb is that when considering taking the entrepreneurial leap, you should generate and evaluate at least ten different opportunities. 

The process of identifying or generating a large set of opportunities and then selecting one or a few to pursue further is an innovation tournament. This tournament need not involve a large group of people. In fact, you can run that tournament by yourself.

There are two parts to an innovation tournament — (a) generating the initial candidates and (b) selecting the exceptional few. Let’s start with the end in mind and consider selection criteria. Then, I’ll give some guidelines for generating opportunities.

Selection Criteria

The motives and selection criteria for a new venture depend on you and your co-founders, if any. You might want to do something in Brazil or be involved in the skiing industry. Make a list. Be very specific about the desirable attributes of your future business. This list is usually quite personal. For instance, when I started MakerStock, one of my selection criteria for this new business — after having made and sold scooters for 20 years — was that our product would not be intrinsically dangerous, as are wheeled vehicles. In my old age I prefer not to think about customers getting injured with my product. You will have your own set of hopes, fears, and desires.

In addition to any idiosyncratic preferences you may feel, the following questions are always important:

  1. Would you be excited, passionate, and proud to tell others, including your family, what your venture does?
  2. Is there enough TAM that you can create an enterprise of significant value? (See the chapter on market sizing.)
  3. Do you have a credible thesis for how you might offer value relative to existing companies (e.g., superior solution, strong brand, network effect)? (See the chapter on alpha assets and sustainable advantage.)
  4. Are your skills, credentials, and/or prior experience particularly relevant to success?
  5. How much capital will be required to pursue this opportunity? Is this capital requirement aligned with your vision for the type of business you hope to create, say a closely held lifestyle business versus a venture-backed company that goes public?

After considering these questions and your personal preferences, explicitly articulate your selection criteria so you can use them to evaluate the opportunities you are considering.

Here is a template (as a Google sheet) to use in evaluating opportunities.

Guidelines for Generating Opportunities

The process of generating opportunities usually plays out over weeks, months, or even years. Start a list. Accumulate ideas as they arise from whatever source. In addition to passive accumulation of ideas, you’ll benefit from focused, deliberate efforts to generate opportunities. Here are some guidelines, techniques, and heuristics for generating more and better ideas.

Push versus pull. Two distinct approaches to innovation are push and pull. With push, you start with a solution — say blockchain technology — and go looking for a market need. With pull, you start with a pain point experienced by consumers or businesses and you devise a solution. As a general rule you should take the pull approach. Identify a problem that potential customers have and then develop a solution that solves it better than existing options. The push approach can work on occasion, say when you start with a fundamental innovation in materials science that has the potential to be broadly useful. However, the push approach has proven to be much more risky than when you start with a pain point that is clear and obvious.

Second-best ideas. Learn from other entrepreneurs and ask them for ideas. Most successful entrepreneurs have dozens of ideas. They are working on their best idea, but you should ask them what is their second-best idea. Many will happily give you ideas and maybe even help you get started. 

Imitate but better. find successful ventures in a field that interests you and improve on their offerings by adding new features or benefits, reducing costs or risks, targeting new segments or markets or creating a unique brand identity. Hundreds of interestiong new ventures are listed by AngelList, WeFunder, StartEngine. YCombinator. Crunchbase, and other organizations. Existing start-ups are a treasure trove of information on what has been tried, what is working, and what approaches have failed. You will not usually want to go head to head with an exact replica of an existing company for two reasons. First, differentiation is a good thing allowing multiple companies to flourish by serving different segments. Second, there’s no particular reason to believe a start-up a few months ahead of you has taken the best approach.

Scour social media. Use social media platforms like Reddit, Quora, and Twitter to find out what customers are talking about, what problems they have and what solutions they are looking for. Monitor trends, hashtags, influencers and feedback. Journalists, bloggers, and conference organizers are in the business of sensing. While their insights are available to everyone, not everyone is viewing those insights through an entrepreneurial lens.

Careful of gold rushes. On-line forums and media outlets will occasionally exhibit fad-like behavior and herding. For instance, as I write this, these forums are crowded with excitement about large language models, chat bots, and artificial intelligence. Unquestionably opportunities abound. However, you can not typically observe the number of rivals entering a new market, and some markets are gold rushes, with too much competition. You may be better served by a quieter niche.

Import from another geographic region. Innovations are often geographically isolated, particularly if introduced by smaller firms. You can sense opportunities by identifying outstanding products or services in a distant region and then considering how you might adapt them to a different place.Translating the innovation from one geographic region to another can be a source of innovation.  

Consider lead user innovation. identify users who have a high need for your product or service and are ahead of the market in terms of innovation. Observe how they use your product or service and what modifications they make to it. Incorporate their feedback and suggestions into your product development.Firms have ample incentive to innovate. Innovation, after all, can result in new sources of cash. But lead users and independent inventors may have even greater incentives. Lead users are people or firms that have advanced needs for products or services that are not being met by other companies. They must either tolerate their unmet needs or innovate themselves to address them.

Poke around universities. Major research universities are wellsprings of opportunities and have produced such successes as Google (Stanford), Genzyme (MIT) and many others. Some of the opportunities spring from faculty-led research, particularly in the life sciences. Others are created by the legions of bright young students who enroll to chart new directions in their lives and careers.

Learn from Others

Here are several interviews I’ve done with founders that have particularly interesting origin stories. Sample the ones that interest you. Most interviews are about 25 minutes long and the origin story is usually in the first third of the interview.

Coravin (Greg Lambrect) – wine dispensing

Eat Just (Josh Tetrick) – alternative protein

Rebellyous Foods (Christie Legally) – alternative protein

Frutero (Mike Weber and Vedant Saboo) – ice cream

Flava Naturals (Alan Frost) – nutraceuticals

Carrot (Tammy Sun) – fertility services

The Infatuation (Chris Stang and Andrew Steinthal) – restaurant guide

Notes

Ulrich, Eppinger, Wang. Product Design and Development. Chapter “Opportunity Identification.” 2020. McGraw-Hill.

Terwiesch and Ulrich. Innovation Tournaments. Chapter Opportunity Identification. Harvard Business Press. 2009.

Terwiesch and Ulrich. The Innovation Tournament Handbook. 2023. Wharton School Publishing.

Introduction to Entrepreneurship

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It’s more fun to be a pirate than to join the navy.

Steve Jobs

What is Entrepreneurship?

Entrepreneurship is the creation of a new economic entity to do a job in society.

The hallmarks of entrepreneurship include a focus on solving a problem, creative exploration of solutions, experimentation to reduce uncertainty, formation and operation of a new organization, and dynamic planning based on new information. Skills in these areas are valuable not just in starting a new company, but in addressing new problems in existing organizations. Thus, many but not all of the elements of this handbook are relevant to those engaged in innovation within established enterprises.

Founder Motives

Kerr and colleagues (2018) provide a comprehensive review of the academic literature on founder motives. (See “Notes” at the end of each chapter for links to references.) You can read that paper if you want to go deep. But, if not, here’s the TLDR. Founders are usually motivated by multiple factors to start businesses. These motives can be usefully divided into three broad categories: purpose, fun, and money.

Purpose

Uma Valeti, a cardiologist by training, and founder of Upside Foods (formerly Memphis Meats), told me that he started the company because he wanted to detach slaughter from meat production. He recalled a birthday party he attended as a child in India in which there was a party celebrating life in front of the house, while others were killing an animal in back of the house. That event made a deep impression on him. Many years later when he worked on the technologies for growing human heart tissue in a medical context he recognized that his knowledge could be applied to another purpose in which he believed deeply. To pursue that purpose, he founded Upside.

Listen to some founder stories. A significant fraction will include phrases like “I had to do it” or “If I didn’t do it, who would?” or “I felt the world really needed this solution.” These are all expressions of purpose — a motive to create something new in order to provide a solution to a personally important problem to the world.

Fun

Steve Jobs said, “it’s more fun to be a pirate than to join the Navy.” That was certainly true for Jobs, but maybe not for you.

Some distinctive characteristics of the daily experience of being an entrepreneur include:

  • Nearly complete autonomy (as long as you don’t run out of cash).
  • Highly diverse tasks (from shopping for insurance to designing a user interface).
  • Privilege of working with a small tight-knit team, largely of your own choosing.
  • Ability to see immediate results of your work.
  • Creating something from nothing, whether a product or a company culture.
  • Continual opportunities to learn something new.
  • Complete absence of boredom.

For me, these attributes are mostly positive, and my own skills and capabilities are pretty well suited for these aspects of entrepreneurship. Entrepreneurship also comes with some characteristics experienced as negative by some people:

  • The complete absence of boredom may be experienced as unrelenting and intense demands on attention.
  • Significant stress about possibility of running out of cash.
  • May be a solitary effort, especially initially.
  • Requirement to do what needs to be done, sometimes including packing boxes or cleaning the office, without an ability to delegate to competent corporate employees.

On balance, most entrepreneurs seem to find the daily work of entrepreneurship fun, and preferable to working within an established enterprise owned by someone else. For some entrepreneurs, the adrenaline and satisfaction from the daily work of entrepreneurship is the most important motive for their career choice. For me, entrepreneurship has been personally demanding. I am extremely thankful to have been a full-time CEO when I was 39-43 years old. I’ve enjoyed being a part-time co-founder many other times. I’ve also been a business owner with ultimate responsibility for an established business for twenty years, but that has a very different stress profile from starting something from nothing. I do not need to have the experience of full-time founder and CEO again, and can get just the right level of fun without a lot of stress from being an investor and advisor.

Money

The mean financial outcome for a capable and educated entrepreneur is likely a bit higher than for those who work in corporate jobs. However, the mean value masks a huge amount of variation. The modal and median outcome predicts that you will fail to realize significant value and would have been better off financially if you had kept your job instead of becoming a founder. Large financial payoffs are realized by a small fraction of entrepreneurs. In approximate terms, about 25 percent will do better than break even financially relative to staying on a traditional career path. About 5 percent of founders with your skills and capabilities will become reasonably wealthy (say USD 5-10mm after-tax pay out), and 1-2 percent will become downright rich (say USD 20mm+ after-tax pay out). For most people, the only way to have a decent chance at becoming wealthy in life (other than being born into it) is to start a business. But, it’s just a decent chance, say 10 percent or so, depending on your definition of wealthy. The probability distribution is also quite different for different types of ventures (more on that below). On the other hand, for most of you, the down side is not that bad. You had an amazing adventure. Worst case you gave up (a) savings worth a year or so of living expenses and (b) the opportunity cost of not having earned a market-rate salary for the years your business struggled. Then you went back to a regular job and did just fine. (See Botelho and Chang; and Amornsiripanitch et al. for a more comprehensive exploration of the implications founders returning to corporate jobs.)

I don’t have a large enough sample for statistical validity, but of the 100 or so Wharton alumni entrepreneurs I have followed closely or invested in, 100 percent live comfortable lives, take vacations, and send kids to college. Five-ish are what most would consider rich (e.g., USD 100mm+). Ten-ish are pretty wealthy as a result of entrepreneurship. Twenty-ish did just fine – let’s say better than having taken a corporate job. The other 65 percent would likely have been better off financially if they had devoted the attention they gave to their venture to a corporate job, and many of those are back working at such jobs.

If you really want to dig into the details on financial outcomes, the Angel List data is probably the best. An index of the available data is here:

https://www.angellist.com/blog-categories/data

You can find the data on venture returns here, from which you can impute a probability of a successful financial outcome.

https://www.angellist.com/blog/venture-returns

Angel List has also integrated its experience into a white paper here: https://angel.co/pdf/growth.pdf 

Types of Ventures

Not all ventures assume the same level of risk and uncertainty.

Read this article from Outside Magazine about Steve Despain (or listen to the Audm version of the story linked in the article). Steve is the founder of Firebox Stoves, a small business tightly coupled to his personal passions and lifestyle. What motivates Steve? How attractive is the Firebox Stoves business to you? (Here, I’m not necessarily asking you about your passion for the outdoors…but about owning and running a small business aligned with your passions.)

Now consider Blake Scholl (founder of Boom Supersonic). Here is an interview I did with Blake when he had just recently founded his company.

What motivates Blake? What does the financial payoff probability distribution look like for Blake vs. Steve? To make this concrete, what is the probability of a zero outcome for each? What is the probability of USD 100mm outcome for each? Estimate some probabilities in the middle, say USD 1 mm and USD 10 mm.

Rich or King?

A key dilemma most founders make is to be rich or to be king. (See Wasserman for a full elaboration of the dilemma.) The skills and capabilities required to lead a large, successful organization are quite different from those required to kick start a new venture. Some founders, such as Bill Gates, Mark Zuckerberg, and Jeff Bezos, did just fine in making the required transition. More typically, a founder faces a dilemma. Do I prefer to retain full control and manage my own kingdom, even if small, or would I prefer to step aside if necessary to ensure a huge financial outcome for investors, including me. Founders do not have to make this decision on day one, but still benefit from thinking through their preferences in advance. A self assessment of your skills and capabilities, and your relative preference for financial success versus control, should influence the type of venture you start.

Founder Characteristics

Founders are not typically kids. The mean age of founders of the fastest growing 0.1 percent of companies is 45. (See Jones, KIm, and Miranda.)

Founders do not require particular personality traits. No personality trait is predictive of success in entrepreneurship specifically, although the “big five” trait conscientiousness does predict career success more generally. (See Kerr, Kerr, and Xu.)

As long as you are not allergic to risk and uncertainty, your personality profile (e.g., introversion, agreeableness or lack thereof) probably does not disqualify you from entrepreneurship.

How do Founders Spend Their Time?

Every founder and every start-up is unique. Still, looking at the experiences of other founders can be instructive. Here is an unusually detailed analysis of how one founder spent his time in the first two years of his start-up.

Entrepreneurial Narratives

Entrepreneurs often follow the hero’s journey and so their stories can be compelling. Take some time to immerse yourself in some entrepreneurial journeys. Select from the following options.

Books

  • Chip Wars. (This is a fantastic and comprehensive history of Silicon Valley and the semiconductor industry. This book will teach you about entrepreneurship, technological innovation, competitive advantage, and geopolitics.)
  • Shoe Dog. (If you can’t stand to go deep on semiconductors, try running shoes.)
  • Let my People Go Surfing. (Memoir by Yvon Chounaird, founder of Patagonia, and a pioneer in corporate responsibility.)
  • The Wright Brothers. (Fantastically interesting book, at least to me.)
  • Truck Full of Money. (Entrepreneurs can be quirky. Paul English, founder of Kayak, is the subject of a fascinating book that goes deep on character. If you like this one, then make sure to read Mountains Upon Mountains, Kidder’s biography of Paul Farmer, founder of Partners in Health – a social venture.)

Films

  • General Magic (film) – This is the basis of a case discussion in my course on Product Management (Wharton OIDD654), so you might wait on this one if you plan to take that course.
  • Print the Legend (film) – about the formation and growth phase of Makerbot, the 3D printing company.
  • (Docudrama just for fun.) The Entrepreneur – The story of Ray Croc, who built the modern McDonald’s corporation.

I know these films and books mostly feature white American males. (Chip Wars does feature Morris Chang, a Chinese-American entrepreneur, and includes mention of the remarkable contributions to the semiconductor industry of Lynn Conway, whose personal story as a transgender female is incredible.) If you have some suggestions for more diverse stories, please send them to me.

Notes

Interview of Uma Valeti, founder of Memphis Meats (now Upside Foods). by Karl T. Ulrich. SiriusXM Launchpad. February 28, 2017. https://shows.acast.com/wharton-entrep/episodes/uma-valeti

Mollick, Ethan. The Unicorn’s Shadow: Combating the Dangerous Myths that Hold Back Startups, Founders, and Investors. University of Pennsylvania Press, 2020.

Jones, Kim, and Miranda. https://ssrn.com/abstract=3158929

Wasserman, Noam. The founder’s dilemmas: Anticipating and avoiding the pitfalls that can sink a startup. Princeton University Press, 2012.

Tristan L. Botelho, Melody Chang (2022) The Evaluation of Founder Failure and Success by Hiring Firms: A Field Experiment. Organization Science 34(1):484-508.

Amornsiripanitch, Natee and Gompers, Paul and Hu, George and Levinson, Will and Mukharlyamov, Vladimir, “Failing Just Fine: Assessing Careers of Venture Capital-backed Entrepreneurs Via a Non-Wage Measure,” National Bureau of Economic Research Working Paper, No. 30179, June 2022. (Summarized by Harvard Business Review here https://hbswk.hbs.edu/item/why-a-failed-startup-might-be-good-for-your-career-after-all )

Azoulay, Pierre and Jones, Benjamin F. and Kim, J. Daniel and Miranda, Javier, Age and High-Growth Entrepreneurship (April 2018). NBER Working Paper No. w24489, Available at SSRN: https://ssrn.com/abstract=3158929 

Kerr, Sari Pekkala, William R. Kerr, and Tina Xu. “Personality Traits of Entrepreneurs: A Review of Recent Literature.” Foundations and Trends in Entrepreneurship 14, no. 3 (July 2018): 279–356.

Angel List Power Law paper https://angel.co/pdf/growth.pdf

TAM, SAM, SOM and the Beachhead Market

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Most investors agree that the two most important factors in a decision to invest are the market size and the quality of the team. This chapter focuses on market size.

The most common ways to think about market size, and the estimates most institutional investors expect to see are:

  • Total Available Market (TAM – pronounced as a word like “ham.”). Sometimes also total addressable market. The market value of the job to be done for all segments.
  • Serviceable Addressable Market (SAM as in a person named “Sam.”). Sometimes also segmented addressable market or serviceable available market. The size of the market you could reasonably serve with your solution and business model in the medium term.
  • Serviceable Obtainable Market (SOM, as in the nickname for a sommelier) – sometimes also share of market. essentially the market the company may credibly expect to obtain with available resources in the near term, say 24 or 36 months.

Some investors, advisors, and entrepreneurs (including me), prefer to define an additional category, the beachhead market. Getting a company up and running is really hard. Going after the biggest market segment is not necessarily the best strategy. Often the biggest market segment will demand aggressive pricing and thus significant cost efficiencies. Most start-ups won’t be equipped to tackle the biggest segments from the start. A beachhead market is one that provides the easiest access, allowing the fledgling business to get started, to develop a little traction, to build some scale, and to refine its products. The beachhead market is always a subset of the SAM. The desirable characteristics of a beachhead market are:

  • The needs of the beachhead market are not being served well by competitors.
    • You can access the customer using focused, efficient acquisition techniques as opposed to broad-based awareness campaigns.
  • Specific customers are readily accessible for engagement in refining a solution.
  • Your value proposition, even as a young company, is compelling.
    • For goods and services requiring physical operations and logistics, the beachhead market is often geographically close to the start-up location.

The boundaries of these definitions are somewhat arbitrary, and so my primary recommendation is to be extremely clear about your definitions and careful with your assumptions. One of the biggest sources of delusion in entrepreneurs’ pitch decks is wildly unrealistic estimates of market sizes.

Top Down Estimates

There are two ways to think about market definition and sizing, top-down and bottom-up. With the top down approach, start with all economic activity on earth – that’s the maximum size of the market for “do everything.” Then, successively narrow the definition of the market until you get to the “market for the job that we aspire to do in society.” That’s your total available market (TAM). Then, further narrow to markets for which you can offer a value proposition in the medium term with your solution – the serviceable addressable market (SAM). Then, further narrow to the first market segment you will focus on and for which you offer a value proposition — the beachhead market. Each narrowing is a defined subset of a larger market.

For example, let’s revisit MakerStock (originally described in the handbook as “University Panel Supply”).

The GDP of the entire planet (c2023) is approximately USD 100 T.

The subset of that GDP representing the market for plastic, wood, and metals used in making things, and excluding construction, is approximately USD 6 T.

The subset of that market for plastic, wood, and metal panels (e.g., large sheets of material) used in making things is approximately USD 700 B.

The subset of that market comprised of specialty plywood (which excludes softwood plywood used in construction), medium-density fiberboard, and acrylic sheet is USD 44 B.

The US portion of that market is USD 5 B. (Now we are focusing geographically.)

The US market for these materials in which the customer’s ideal format is a less-than-full-sheet custom size with delivery by conventional ground freight is USD 500 mm. This is the subset of the market for which a cut-to-size supplier of materials would offer a value proposition. This particular focusing step is where you might sense we are pretty much guessing. There is no place to look up market sizes for the “cut to size” panel market, and we are left to doing some back-of-the-envelope calculations. For this reason, top-down estimates become a bit shaky as additional focusing assumptions are made. Still, USD 500 mm is a reasonable estimate of the TAM for MakerStock — the market is certainly smaller than USD 1 B and it’s more than USD 100 mm. The definition of your TAM is somewhat arbitrary. For instance, this estimate of TAM is for the US only, but might we reasonably consider serving customers in Europe, for example? Given that many different assumptions are possible, just be very clear about the focusing decisions that underly your estimate of TAM.

MakerStock’s TAM includes cabinet makers and raw materials for factories producing finished goods in relatively large quantities. MakerStock is unlikely to be competitive for these segments in the medium term. The company is likely to offer a stronger value proposition to customers that prefer custom sizes and that order a variety of different materials, both wood and plastic, for use in their fabrication processes, largely laser cutting. The US market for such materials for university maker labs, do-it-yourself individual makers, and small- and medium-sized businesses such as sign making shops is approximately USD 100 mm. This is a reasonable estimate of the SAM for MakerStock.

Now, how will MakerStock get started? Where will it focus initially? MakerStock will focus on university maker labs. It will focus on those labs that can be served by FedEx ground freight within three days of Scranton, Pennsylvania. The beachhead market is for pre-cut specialty plywood, medium-density fiberboard, and acrylic sheet for university maker labs located within the three-day ground shipping territory from Scranton, Pennsylvania. Top-down estimates are going to be very approximate for the beachhead market. To do a top-down estimate, we might gather some estimates (guesses?) of a few knowledgable people and average them and assume that 10 percent of the SAM is the beachhead market, delivering a market size of USD 10 mm. Bottom-up estimates are much better for tackling this estimate, the approach I will explain below.

With each successive focus on a subset of a larger market, we are making a decision about which narrower market will be more readily addressable by the new venture. Each narrowing reflects a belief which may or not be correct. For instance, commercial sign makers may be a better beachhead market than university maker labs. So, as with any problem solving activity, considering alternatives and testing beliefs will likely result in better outcomes.

For the top-down approach, conventional internet search and current AI tools are probably the best source of raw data. By using a variety of queries and triangulating on the result, you are likely to be able to make estimates that are well within one order of magnitude of the actual value.

TAM and SAM depend on the definition of your core business

Estimating TAM and SAM requires that you assume some boundaries for your core business. For instance, if I conceive of my panel supply business as providing panels of any type to any user of panels globally, my TAM is USD 700 B. But I really have to stretch my imagination to believe I can address the need for particle board panels purchased by the Chinese factories that make the best-selling IKEA Billy bookcase. Those factories are likely purchasing many full truckloads of those panels per week directly from the mill that makes them. The definition of available and addressable determines your TAM and SAM. I like to think of addressable customers as those customers who have a job to be done for which the core business could reasonably be competitive in delivering a solution. For MakerStock, that core business is sourcing sheet goods by the full truckload, breaking the bulk delivery into sheets, cutting sheets to custom sizes, and delivering pieces by conventional ground freight. The job to be done is to deliver an assortment of the right materials, at the right time, in the right sizes, all with minimal fuss. The serviceable addressable market is the size of the market for which that value proposition makes sense, a market not of USD 700 billion but rather about USD 100 million.

Bottom-Up “Counting Noses” Approach

The top-down approach is a useful way to put the business into a larger context, and to reveal possible additional market segments, and their sizes. However, the bottom up approach is usually more credible and less speculative. WIth the bottom-up approach, you start with a hypothesis about the beachhead market — the very first market you will tackle. You estimate the size of that market by creating an inventory of every potential customer in that market. This approach is called counting noses.

For example, the beachhead market for MakerStock is university maker labs located within the geographic region served by three-day ground shipping from Scranton, Pennsylvania, the initial location of the business. The business was located there because I as founder already had a facility and an available team member in that location, and because that location is a logistics hub, serving about one third of the US population within two days by conventional ground shipping. The geographic cut off reflects a belief that freight costs would be decisive in the value proposition to our customers.

Once that beachhead market is defined, counting noses is easy. First, there are about 5300 colleges and universities in the United States. Now, look up the ground delivery time map that FedEx provides. Identify those universities within the three-day shipping territory. That subset is about 2500 institutions. This set of 2500 potential customers can be identified and cataloged precisely and entered into a database. For each potential customer, say PennWest Edinboro University, an internet search can reveal whether or not it has a maker lab, and possibly unearth a name and contact information for the lab manager. In fact, an internet search for the PennWest Edinboro furniture design program yields a great description of the program, including photographs displaying specific details about the equipment and furniture in the shop. That search even produces a name of the program director, Karen Ernst, along with her contact information. We can now count Professor Ernst’s nose in our beachhead market. Doing a comprehensive search for all 2500 potential customers is probably not a good use of time until the business is actually launched, but doing that search for a sample of potential customers, say a hundred, produces an accurate estimate of how many labs would eventually be found in all 2500 universities. For this example, a preliminary search suggests that about 64 percent of these universities have at least one maker lab, a potential customer base of 1600 labs.

At this point, some assumptions are required about the average level of spending on speciality plywood, medium-density fiberboard, and acrylic by each lab. That estimate can be based on interviews with a sample of customers. By talking to about five potential customers, we found that the average spending seemed to be roughly proportional to the size of the university, with a university spending an average of about USD 4 on these materials per year per student enrolled. The labs serve an average of 1250 students each, so their average spending on materials is about USD 5000 per year. These figures lead to an estimate for the total size of the beachhead market of USD 8 million per year (i.e., 1600 labs at USD 5000 per year). This a pretty solid number. The real value might be USD 10 million or USD 6 million, but it’s not USD 50 million or USD 1 million.

Consider Adjacencies for a Bottom-Up Estimate of SAM

Once you have identified and characterized a promising beachhead market, now consider the immediately adjacent markets. The adjacencies might be geographic. So, after considering colleges and universities in the northeast, consider those in the mid-Atlantic region, or the mid-west. The adjacencies might be in the goods and services offered, for instance extension of the product line from wood and plastic to metals. The adjacencies might be in the types of target customers, for instance from colleges and universities to secondary schools, or to small and medium-sized businesses using laser cutters. These adjacencies taken together comprise your SAM, as estimated using the bottom-up approach. As a matter of good planning hygiene, consider how your bottom-up estimate of adjacent markets compares with your top-down estimate of your SAM. These two ways of getting to SAM should not deliver wildly different results.

Estimating SOM

Recall that SOM is the market you plan to actually serve within your planning horizon, usually 24 or 36 months. For my taste I prefer estimating SOM with a bottom-up, counting noses approach of the beachhead market integrated with some estimates of the rate of customer acquisition of the go-to-market system.

Recall that we estimated that there are 1600 potential customers in this beachhead market. I believe we can acquire an average of two new repeat customer per week with the likely sales and marketing resources we will have, net of churn. (See the chapter on go-to-market systems for how to think about this.) Thus, within three years, we will have approximately 300 university maker labs as repeat customers. We estimated earlier that each lab orders approximately USD 5000 in materials per year. Thus the recurring revenue for the customer base at year three will be approximately USD 1,500,000 per year, at which point we will have about 19 percent market share of the beachhead market of USD 8 million. Of course, even though we will focus on the beachhead market, we will unavoidably reel in some customers from adjacent markets, and likely will also sell to some do-it- yourselfers via the MakerStock website. It’s even possible that an adjacent market will prove to be a better fit for the company than the beachhead market we had originally envisioned. Still, the bottom-up nose counting along with some realistic modeling of the go-to-market system is a grounded approach to forecasting the scale of the business.

Fables Versus Realism

None of you readers are too excited about recurring annual revenue from the beachhead market of USD 1,500,000 after three years. Investors likely would not be too excited either. Yet, that’s actually an above-average outcome for a start-up in year three. I have invested in over 50 start-ups. About five of those have achieved recurring annual revenue of USD 1,500,000 by the end of year three.

Every founder faces many dilemmas. One of the most pressing is whether to spin a compelling fable in the pitch deck, which probably represents a 95th percentile outcome, or to provide a realistic forecast of what you believe to be a highly obtainable outcome. I believe the level of conservatism in the forecast depends on the audience. If you are planning to be a closely held, bootstrapped, company, then you should strive for hard, cold realism, even pessimism. That was my approach with MakerStock. I funded the business with my own money. I wanted to have a realistic sense of how the business would unfold and how much cash I would need to burn to get to positive cash flow. MakerStock actually did substantially better than the forecast, largely because do-it-yourselfer and small- and medium-sized business customers turned out to be fairly easy to acquire and serve alongside universities. That was a pleasant surprise easily accommodated as the business developed.

If, however, your audience is institutional investors, then they are highly conditioned to see forecasts at about the 95th percentile. My advice is to be excruciatingly clear about your assumptions and logic in estimating TAM and SAM. Those need to be highly credible. Then, the estimate of SOM should likely skew a bit optimistic, assuming that you have all the resources you need, including that investor’s capital, and that things go well. Your SOM is going to be discounted by institutional investors seeing your pitch, so you should account for that fact in your presentation. (Yes, I realize this is a pernicious cycle of optimistic forecasting and assumed discounting by the investor. I don’t see a clear way around it.)

Market Size Graphics

The most common way market sizes are shown in pitch decks is with nested circles, sometimes called an onion diagram, in which the area of the circle is proportional to the market size. Data graphic purists may prefer bar charts of some kind, but I think the nested circles work pretty well and you probably want to avoid bucking convention here. You can, of course, annotate this graphic heavily to support the numbers.

Notes

VC Factory Article on TAM, SAM, and SOM. Decent article from a venture capitalist’s perspective.https://thevcfactory.com/tam-sam-som/

Go-to-Market (GTM) System

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This little piggy went to market,
This little piggy stayed home,
This little piggy had roast beef,
This little piggy had none.
This little piggy went …
Wee, wee, wee,
all the way home!

Mother Goose

What is Go to Market?

Go to Market or GTM is a term of art originally used in the enterprise software industry in Silicon Valley. At first glance, you would understandably think the term referred to the activities a company takes to launch its product in the marketplace. The product is done, and then “this little piggy goes to market.”

But as used in Silicon Valley, go to market is better defined as:

The system by which a company transforms its addressable market into its customer base. 

Another reasonable definition is:

How we convert a potential customer to a delighted customer.

Or even:

How we sell stuff. 

(But, this last definition fails to emphasize the importance of deliberate management of customer success to ensure long-term value for both customer and supplier.)

GTM is an on-going operating system – an engine – which is developed, refined, and operated over the life of a product to grow revenue. In most settings, the GTM system is the second most important design challenge a new venture faces, closely following the design of the solution itself.

In some (relatively rare) settings the relationship between customer and supplier consists of very few transactions and a limited on-going relationship persists. For instance, one of my former students Ajay Anand founded Rare Carat, a marketplace for diamond engagement rings. Notwithstanding exceptional potential customers like actress Elizabeth Taylor who was married eight times, the modal number of transactions Rare Carat will have with a customer is one. Go to market for Rare Carat is pretty simple – gain awareness, encourage trial of the service, and convert trials to ring purchases.

At the other extreme are enterprise software companies like Salesforce. It may take significant effort to acquire a customer, but once acquired, that customer is likely to remain a source of revenue for many years.

Here are some of the activities that comprise the GTM system in many organizations:

  • Creating awareness of the company’s solution.
  • Encouraging consideration and trial.
  • Supporting selection of the company’s solution.
  • Pricing the solution for a specific customer.
  • Delivering the solution, including associated hardware, software, and integration with the customer’s existing operations and activities.
  • Training the customer and ensuring effective adoption of the solution.
  • Up-selling and cross-selling additional solutions.

Scaling a business requires efficient processes that can be reliably replicated. Just as an industrial process like making automobile tires could not possibly be scaled efficiently without a codified process, so a GTM System can not be scaled if not codified.

Two Basic Types of GTM Systems – Product-Led Growith (PLG) and Customer-Led Growth (CLG)

Although every GTM system is different to meet the specific needs of a company, two basic types of GTM systems are common: Product-Led Growth (PLG) and Sales-Led Growth (SLG).

Key Characteristics of Product-Led Growth (PLG)

An example of PLG is the video conferencing tool Zoom. Product situations for which PLG may be effective include:

  • The customer can deploy the product without assistance.
  • There is a practical mechanism for a potential customer to try the product at low or no cost.
  • The product is intrinsically viral (e.g., visible in use, sharing is integral to use of the product, novel and interesting).
  • The effort and time required by the customer from the adoption decision to realization of significant value is low.

Key Characteristics of Sales-Led Growth (SLG)

An example of SLG is the human-resource management enterprise software product Workday. Product situations for which PLG may be effective include:

  • The product requires a significant effort to provision and set up.
  • The product lacks intrinsic virality (e.g., not readily visible by others; not intrinsically interesting or novel; sharing or connecting with others not an organic element of the use of the product).
    • The effort and time required by the customer from the adoption decision to realization of significant value is high, often USD millions over years.

The GTM Canvas

You can represent the GTM system with a GTM Canvas, a template which works for most settings. Here is a GTM Canvas as a Google Sheet. This is the GTM Canvas for the now familiar MakerStock example.

The Customer Journey

The backbone of the GTM System is the customer journey. To fill out the GTM Canvas, start with the customer journey.

The journey starts with the customer’s job to be done. The journey is complete when the customer is committed and delighted to be using your solution to do the job.

All customer journey’s include at least these touch points:

  • Awareness of the company’s solution.
  • Consideration of the solution relative to competitive alternatives.
  • Decision to try or adopt.

KPIs

The development of key performance indicators (KPIs) for the GTM system begins with a metric for the desired result. For example, for MakerStock, the desired result is a satisfied customer, defined as:

MakerStock is the primary supplier of panel goods for the lab. The lab is purchasing in regular intervals with order sizes of at least USD 800. The institution has set up an account and is paying via bank transfer or check (to avoid credit card fees). We know the lab manager’s name and preferred mode of contact and have interacted one-on-one. The lab manager is highly satisfied with MakerStock’s services and would recommend MakerStock to others.

The KPIs for this desired result are the number of satisfied customers, the number of new satisfied customers obtained this week, and the average net promoter score (NPS) of satisfied customers.

KPIs should also reflect the state of the intermediate phases in the customer journey. For example, how many potential customers received a quote this week, and how many potential customers have received a quote within 60 days but have not placed an order.

Finally, KPIs should also reflect key actions that serve as inputs to the GTM system. For instance, how many outbound email inquiries to potential customers were made this week.

Process for Designing GTM System

Ideally you will have just one GTM system, but will probably eventually have to create variants for very different segments. For each segment, proceed as follows.

  1. Define the focal market (usually the beachhead market for a start-up) and the job to be done.
  2. Define a goal state for the customer. Success is usually a delighted customer for whom your product is accepted as an integral element of how they do the job.
  3. Map the phases in the customer journey, from “potential customer” to “delighted customer.”
  4. Create the playbook for the transitions between phases using design thinking, experimentation, analytics, and iterative refinement.
  5. Establish ownership of each playbook and the handoffs between functions (e.g., sales to customer success).
  6. Select KPIs for the most significant elements of the GTM system, for both results and key process steps.
  7. Once you believe your GTM system is approximately right, consider the GTM as a process flow and work out yields and flow rates to deliver desired growth targets. This step is useful for testing the feasibility of efficiently acquiring customers and for establishing budgets for sales and marketing efforts.

Complications

Two complications are common in creating GTM systems: (1) platform and marketplace products and (2) multiple segments with multiple channels.

Platforms and marketplaces

Platforms and marketplaces are sometimes called two-sided markets because they bring together suppliers of goods and services with consumers of those goods and services. The solution serves two very distinct types of customers and users. Some sales and marketing activities, such as general brand awareness, may serve both sides of the market. However, almost certainly, two very different GTM systems are required for two very different segments. The GTM systems can be conceived of independently. However, in operating the GTM systems, the two sides of the market must be kept is approximate balance — and so those responsible for the two GTM systems must coordinate with each other, and resources may need to be allocated dynamically across the two systems in order to keep supply and demand in equilibrium.

Multiple segments

Good advice in general for new ventures is to focus on one beachhead market. In that case, the company will have just one GTM system. Inevitably some distinct market segment will emerge. Sometimes that segment can be accommodated with a variation on one or more steps within a single GTM. For instance, for MakerStock, the GTM system is designed for universities, but when a high school emerges as a potential customer, the GTM system can pretty easily accommodate it with some minor differences (e.g., awareness of summer shut down dates, central school district billing systems, higher price sensitivity).

Sometimes a new market segment is so different that it requires that the GTM system be forked. For instance, the do-it-yourself (DIY) consumer segment became important to MakerStock during the 2020, the year the Covid19 pandemic was most severe. At that time, the university GTM system was simply not relevant. Keyword advertising was the key mechanism for gaining awareness and trial for the DIY segment. The sales and marketing playbook for the DIY segment is so different from that of the university lab segment, that MakerStock created an entirely separate GTM system for that segment.

Assignment

Complete a GTM Canvas for your new venture. Again, here is a template for the MakerStock example. (You will of course need to “make a copy” or “save as” in order to create your own version.) You need not use Google Sheets if you prefer some other tool (e.g., Miro).

Craft a one-slide description of your GTM system for the purposes of your pitch deck.

Notes

A pretty good free web-based “book” on GTM.https://unlock.survivaltothrival.com/

Allocating Equity to Teams

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One of the most common challenges faced by founding teams is how to allocate equity in their enterprise. This is essentially equivalent to the challenge of how to value the different inputs required to create the product, service, or company. There are no predefined formulas, but basic economic logic applies here. This figure illustrates how value might be accounted for over the first three phases of a typical new venture.

Usually it is easiest to think about valuing inputs at each of several discrete phases. For example, at the beginning of the “Founder Phase” an entrepreneur has a business concept developed to some level of detail. The value of what the entrepreneur brings to the table at the beginning of the Founder Phase is labeled “IP contributed” on the figure and is shown in yellow. (Here I use the label IP to refer to all the intellectual property created to date, usually comprising business plans, technologies, and other information.) Over the duration of the phase, the venture will typically require two other inputs. One is cash, usually contributed by the founders. This cash is shown in green as “founder’s cash.” (This is usually a modest amount, typically $2,000 – $20,000.) The second input is the “sweat” that the founders commit to contribute over the phase. “Sweat” refers to the labor and ingenuity provided by the founders for which the venture does not pay them wages. 

If the founders are successful in nurturing the business concept during the Founder Phase, they will have created some value and will usually seek additional investment. (The creation of value is reflected in the increased height of the blue bar. It is also possible, of course, that they will fail to create value, in which case the blue bar may decline in height.)  The First Phase investment will usually be in cash (green) and in further sweat from the founders and some new team members (brown). Team members are almost never paid full market wages during the First Phase, thus they are still contributing “sweat.” The cash in the First Phase often comes from so-called angel investors, typically in amounts of $20,000 – 200,000.

If after the First Phase the venture still offers promise, the company may seek additional capital. For a few ventures this capital will be institutional investment from a Venture Capital fund, usually called the “Series A” investment. However, I refer to this phase generically as the “A Phase” whether or not investment is from a venture capital firm. At this point, members of the team and employees are usually paid something close to market wages. However, in most cases, the venture benefits from compensating members of the team in part with equity. I still refer to this as “sweat,” even though it might be more appropriately labelled incentive compensation. In most cases the sweat equity allocated in the A Phase is in the from of stock options, but for simplicity you can think of these options as an allocation of common stock to the team. Most investors expect to see about 10 percent of the total shares outstanding reserved for future incentive compensation. In almost all cases, institutional investors expect this 10 percent to dilute the existing shareholders and consider it part of the “pre-money” value of the business.

Valuing the Inputs to the Founder Phase

There are typically three inputs during the Founder Phase: (1) the IP created to date, (2) the sweat of the founders, and (3) cash. Of these three, only the cash is easy to value. A dollar of cash invested is worth a dollar. But, how do you value the sweat and the IP?

Valuing Sweat Equity

When you place a value on the sweat of the founders, you are essentially creating an equivalence between the cash contributed and the sweat contributed. In other words, an investor (usually one of the founders) who contributes $20,000 gets the same amount of equity for that contribution as someone who contributes $20,000 worth of sweat. In valuing sweat, I have usually taken the approach of estimating the opportunity cost of the time contributed by an individual and then applying a non-cash adjustment factor. For example, assume that during the Founder Phase, Billy will quit his job (or not take a job) foregoing $5,000 per month in income for the four months expected duration of the Founder Phase. Billy is contributing time with an opportunity cost of $20,000. From one perspective, he should get $20,000 worth of equity for his contributions, the same as a cash investor contributing $20,000.

However, I have often applied a “non-cash adjustment” factor to this sweat calculation. By that I mean that I have discounted the non-cash contributions by a factor before comparing them to the cash contributions. Here’s why:

  • Cash is king. A dollar of cold, hard cash is worth more than a dollar of unpredictable, to-be-delivered effort.
  • Cash is invested on an after-tax basis; sweat is effectively a pre-tax contribution (assuming you are smart about how you handle the granting of equity).
  • Sweat is often contributed at the margin by someone who has a day job. The opportunity cost of this time is not usually cash, but rather time with family, pursuing hobbies, or watching TV. Lots of research has shown that people value their non-work time at quite a bit less than their wages at work.
  • Opportunity cost is sometimes inflated, particularly by consultants. People who are used to charging for their time by the hour are inclined to value their time at their marginal billing rate, sometimes $1000 or more per hour. There are of course situations in which this is appropriate. For example, if you need a busy lawyer on your team and that person can bill every available hour at $500, then that’s really the opportunity cost of the time. This is rare. More typically a consultant (e.g., programmer, graphic designer) will commit to working “after hours,” and that time is rarely really worth the marginal billing rate of the consultant. A rule of thumb I have used with consultants is that their inputs are valued at one half of their standard billing rates. (For the record, university professors are one of the few classes of individuals who often do have very high opportunity costs for their time because in most cases their employers limit their “outside activities” to about 50 days per year.)

Depending on how these factors play out in your situation, you will need to apply a non-cash adjustment factor to convert a dollar of opportunity cost of sweat invested to a dollar of cash invested. Having said all this, at the end of the day, the equivalence between cash and sweat is determined by an agreement between the individuals providing these different inputs.

Example 1: A new MBA graduate committing to work for a few months for sweat equity might forgo salary of $40,000. That would be equivalent to about $28,000 of after-tax income. This sweat should be valued the same as $28,000 in cash invested by another founder. (This salary would be for someone in a “normal” job. The masters of the universe who command seven figure salaries/bonuses as traders, etc. are not going to buy into this logic, and you probably don’t want them on your team anyway.)

Example 2: A freelance graphic designer who normally bills her time at $125 per hour agrees to provide 100 hours of sweat to the venture. This input would be valued at $12,500 at the marginal billing rate, but the designer is unlikely to actually forgo paying work to do this. The team agrees to value her time at one half of her billing rate, so this commitment of 100 hours would be valued at $6250 and she would receive as much equity as someone investing that much cash.

You can avoid actually putting a price on sweat if (a) you don’t need any cash, (b) all members of the team contribute equally, and/or (c) all members of the team contribute cash in the same ratios as they contribute sweat. Under those conditions you just allocate equity according the time people contribute. Such conditions rarely hold. Thus, at some point you are going to have to figure out what an hour of Billy’s sweat is worth relative to $1000 of Betty’s cash.

Valuing Intellectual Property Contributed

The short answer to how you do this is that it is a subjective judgment and/or the result of a negotiation between the original founder and the other members of the founding group. Some of the factors that influence the value of the IP contributed are:

  • How refined is the IP? Is it just an idea or is it a working prototype with satisfied users?
  • How original is the IP? Is this a brilliant idea or one that many people have attempted to exploit?
  • How strong is the intellectual property protection likely to be? Is there an issued patent? Can others be excluded from exploiting the opportunity?
  • Is the originator of the IP going to be an integral part of the founding team or does he/she intend to be a passive participant?
  • How much effort (and other resources) has been contributed to date?

I don’t think the originator of the raw opportunity would typically expect less than about 5 percent of the Founder-Phase Equity. I can also imagine an inventor of a new molecule with amazing properties and iron-clad patent protection to command 90 percent of the Founder-Phase Equity.

Estimating Tasks, Effort, and Allocation Among Founders

When dividing up equity for a venture, you benefit from making explicit what the different roles of the founders are and what contributions each will make. As an example, consider how Billy and Betty allocated equity for a venture that did not require significant external cash. Billy had invented a new device (let’s call it “The Widget”). Betty wanted to join in commercializing it. They agreed on the set of tasks that had to be completed. They then independently assessed who would do what and what each task was worth in “points.” (The total number of points ended up being, somewhat arbitrarily, 122.) In this case, they explicitly listed the work that had been completed to date, including the contribution of the “idea.” Remarkably, they agreed to a considerable extent on the relative allocation of points. Here is their actual spreadsheet. (“Billy” and “Betty” are pseudonyms, of course.)

Example Equity Worksheet

Details

Mechanics of Granting Equity to Individuals

There are two basic ways to grant equity to individual members of a venture team. You can grant them restricted stock or you can grant them stock options. Options are much simpler to administer, but as a founder you should avoid them if possible. Here’s why. First, an option is simply a right for a fixed period of time to purchase shares of a company for a predetermined price. If the share price increases, then an option holder can realize value by exercising the option. Options are rarely exercised unless the resulting shares can be sold for cash, as is the case for a publicly traded company or when a company is purchased by another entity. When you exercise an option and then sell the shares you acquire, any gains are treated as ordinary income. This will cost you at least twice as much in taxes than if you were taxed at the long-term capital gains rate. Second, options expire, usually just before they have any value. Third, options are hard to value. Most employees are clueless about valuing their options, pretty much ignoring the exercise price (the “strike” price) in their feeble mental accounting. Of course, as an evil manager, you could use these facts to your advantage and offer options to your employees in an effort to avoid sharing the wealth.

Restricted stock is a much better way to go for core members of the founding team. Restricted stock carries with it some, ahem, “restrictions,” meaning typically that it has a vesting schedule that determines when, if ever, you actually have the full rights of ownership of the stock. Because of the restrictions, the IRS allows the stock to be valued at substantially below the fair market value of the common stock of the company. This is important for tax treatment, in that you must typically pay taxes on outright grants of restricted stock. (At this point, I should warn you emphatically that you need to consult a lawyer and an accountant about the details of restricted stock grants. Otherwise, you could get whacked with a very ugly tax bill and have no cash to pay it…)

Of course, the ideal scenario is to be granted “founders’ stock” when the company is first formed and when that stock has essentially no value. Then, you have essentially no tax liability and any future gains eventually realized will be taxed at the long-term capital gains rate (which is just 15 percent in the US as of October 2011).

What if people don’t do what they committed to do?

In my experience, often some members of a founding team do not deliver on their commitments. If you’ve allocated equity to them in expectation of delivery of a commitment, then you have essentially paid in advance for work that may or may not be done. There are several ways to deal with this problem, none of them perfect.

First, the stock you grant can “vest” (acquire its full value) according to some combination of time and performance milestones. If you can reasonably agree on the major contributions of each member of the founding team, then their stock can vest only when and if those contributions are delivered. The problem here is that it is very hard to determine in advance what all the tasks will be. I’ve been involved with companies in which stock vested proportionally to effort applied to the venture, but I’m not sure those agreements would be viewed favorably by the IRS. (Again, consult your attorney.)

Second, you can exercise caution and only grant equity for contributions expected over a quite limited time period, say half a year. If the team member doesn’t do his or her part, then you won’t make future grants, or will modify the grants in the future. The problem with this approach is that you will have to grant future equity when it presumably has significant value, which is going to have negative tax implications. (Unfortunately, for tax reasons you really want to grant most of the founder’s equity right when the entity is first formed.)

Various forms of preference

The analysis/graph shown above implicitly treats all equity alike. In reality, Series A investment is almost always “preferred stock.” Vanilla preferred stock simply provides for a liquidation preference over common stock. That is, in a down scenario, the preferred shareholders get paid first. Until their principal is returned, the common shareholders get nothing. Preferred stock can generally be converted to common stock before a liquidation event in an “up” scenario. Sometimes preferred stock includes payment of an extra dividend or converts on a greater than 1:1 ratio to common stock in an up scenario, a provision sometimes called “double dipping.” See Andrew Metrick’s excellent book on venture capital finance for details.

Compensating advisors/directors

Are you looking principally for real advice or for a credential/endorsement? If seeking principally an implicit endorsement, see “Contribution of Intangibles” below. If you are seeking real advice, then you should be prepared to pay in equity for the cost of that advice. Advisors tend to value their time at somewhere between $3k and $15k per day. Remarkably, some otherwise saavy advisors don’t bother to analyze equity deals relative to the opportunity cost of their time. These folks have too much spare time on their hands.

Contribution of intangibles

Sometimes you wish to grant equity to advisors or others who are largely contributing their reputations and connections to the venture, rather than contributing significant chunks of time. In my opinion, a reasonable way to think about this is simply how much cash value their contributed intangibles are worth. Obviously, having Oprah Winfrey endorse your product is worth more than having your mother endorse it (except in the very rare case when your mother is Oprah or an equivalent.) You should think about what the intangibles are worth and negotiate an appropriate exchange of equity at the valuation at the time the equity is granted.