Wealth Through Innovation 0.5

Albedrio Partners, Inc.

Wealth Through Innovation v0.5 Prepared for: Prepared by: Marcos Polanco, Principal May 24, 2009

Albedrio Partners, Inc.

1607 Calle Colón #101, San Juan, PR 00911 787.529.5892 [email protected]

www.albedrio.com

Albedrio Partners, Inc.

Introduction “You need three things to create a successful startup: to start with good people, to make something customers actually want, and to spend as little money as possible. Most startups that fail do it because they fail at one of these. A startup that does all three will probably succeed.”

- Paul Graham, founder of Viaweb (sold to Yahoo for $50M) and investor in 80+ startups Entrepreneurs are not alone in their quest to realize their vision, and indeed stand on the shoulder of giants who have outlined the path between entrepreneurial vision and financial wealth. Albedrío partners with entrepreneurs to help them identify valuable opportunities and remove as much risk as possible from their enterprises at the lowest possible cost, thus maximizing the financial value of innovation. This paper outlines the elemental risks faced by an innovative startup, how investors (e.g. the founders) can target financing to remove these uncertainties, and the Customer Development process to handle what is frequently the main risk: market acceptance. Wealth through Innovation A firm’s value to its shareholders is driven by its profit potential and braked by its risk profile, in particular the risks associated with technology development, market acceptance, management capabilities and the business environment: 1. Technology Development means the risk that the technology under consideration will actually fulfill the promised value proposition and satisfy clients. It is important to note that technologies are almost certainly deployed in conjunction with a family of consulting, training, financial and management tools to constitute a complete solution to the business challenge faced by customers. 2. Market Acceptance refers to the number of customers efficiently reachable by the enterprise through the chosen distribution channels, the length of the sales cycle, the win rate for presented proposals, average deal size and the cost of customer acquisition. The risk is that any one of these parameters will be “show-stoppers”, unacceptable in order to generate the financial results sought by shareholders.

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3. Management Capability refers to the probability that a firm’s management team has the competencies and motivation to guide the enterprise to the event that will realize capital gains by the shareholders, typically through an initial public offering, an acquisition or the declaration of a dividend distribution schedule. 4. Business Environment refers to the risks that political, technological, economic or social changes will negatively impact the value of the enterprise’s business offering. Recession, conflict, cultural changes, and scientific discoveries can render offerings practically useless. This risk is managed through speed of execution (thus granting less time for unexpected changes to occur) and continuous monitoring of the change drivers and the firm’s environmental exposure. Example - Part 1: XPR Enterprises is developing a language translation device, targeting a $50M global business market where they expect $10M in annual profits. They estimate that this line of business could be sold for $20M, their objective. However: 1. There is a 60% chance that they can engineer a device weighing less than the required 1lb. 2. The product would require a new distribution channel (80% chance of success) and positioning as a must-have item with a 3-month sales cycle (70% chance of success). 3. The management team is experienced in servicing national $10M markets, but has never sold globally. There is a 70% chance that they can build the competencies to reach the $50M mark. 4. It will take three years to launch the product, so there is a 70% chance that the business environment will remain stable for these above assumptions and calculations to remain true. Thus, to a first approximation, the nominal value of this business today = $20M x .6 x .8 x .7 x .7 x .7 = $3.3M, only 16.4% of what the shareholders wish to sell at. It is management’s job to raise share value to the $20M mark!

How to Finance Innovation Given the above example, where the enterprise is only worth 16.4% of what shareholders are targeting, they are best served by a capital efficient risk elimination approach, through which they ask the question, “What is the least amount of money we can invest that will eliminate the greatest amount of risk in the enterprise?” Once they have eliminated the greatest risks, they can reassess whether they are best served by continuing to

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fund the project. This is the fundamental logic of “venture capital rounds of funding” utilized in Silicon Valley. Example - Part 2: XPR Enterprises estimates that product launch will cost $10M; however, they choose to approve only $1M of funding to fulfill the following objectives within six months: 1. Identify the specific technology breakthroughs required to solve the weight issue through a survey of the leading academic researchers on potential solutions. 2. Conduct a study to determine whether and how to sell the product in less than three-months. 3. Identify the absolute minimum set of features that customers would be willing to pay for, thus reducing the original three years needed to launch to only two years. They choose to retain the existing management team for the moment, as they are perfectly capable of conducting the above tasks, and not to mitigate the distribution channel risk, which would cost and additional $1M. Here’s the before-and-after risk profile sought from their $1M investment: Risk

Before

After

Product

60%

90%

Distribution

80%

80%

Sales Cycle

70%

90%

Management

70%

70%

Environment

70%

80%

Valuation

$3.3M

$7.3M

Therefore, the shareholders raised the value of the company by $4M with only a $1M investment. That is a good return! But if they had been unable to succeed then they must identify the root causes and decide whether to cut their losses at the $1M or continue investing.

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Albedrio Partners, Inc.

The Role of Customer Development in Financing Innovation Customer Development is a four-stage process focused on eliminating market acceptance risk at minimal cost through early engagement with potential customers. The four stages are: 1. Customer Discovery, wherein the enterprise ensures that there exist customers who attest that the offering actually solves a top problem, and that the way in which the offering is acquired is compatible with their business practices. Only the pain of top problems causes customer purchasing action, and the complete solution must be compatible with organizational and industry workflows. 2. Customer Validation, wherein the enterprise develops a repeatable sales process with customers who are willing to accept business startup risks along with company founders. Customers are not only paying the purchase price, but they are also changing internal processes and accepting the possibility of startup failure, which would negatively impact their organization and personal reputation. A successful customer validation exercise must produce the first customer orders. 3. Customer Creation, wherein the enterprise identifies scalable demand-creation channels for new customer acquisition at acceptable costs. 4. Company Building, wherein the enterprise successfully exits the development stage and articulates a mission to dominate a given market segment. Albedrío teams with founders on a capital-efficient traversal of the discovery and validation stages. The first step is to size & type the addressable market, developing hypotheses of the customer problem, minimum viable solution concept, demand creation channel, competitors, pricing model, sales roadmap, whole team competencies, and customer workflow (both before & after product implementation). The second step is to actually perform the investigation of whether the hypotheses are correct, stopping as soon as we find conclusive customer data. The process repeats until it succeeds.

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Albedrío Leadership Marcos J. Polanco is a proven innovator with diverse experience in technology development, entrepreneurship and public policy. Mr. Polanco holds a bachelor’s degree in Computer Systems Engineering from Stanford University, a Master Certification in Professional Management from the Institute for Generative Leadership and an Executive Certification in International Marketing from the Thunderbird School of Global Management. Mr. Polanco began his career performing object database research at Hewlett-Packard Laboratories in Palo Alto, California, and went on to both technical and managerial leadership roles at a number of Silicon Valley startups before co-founding Imana, Inc. to commercialize a social search technology he co-invented and patented. Mr. Polanco served as advisor to the Government of Puerto Rico in the implementation of its Information & Communication Technologies strategic public policy roadmap and in the design of the Puerto Rico Science, Technology & Research Trust, the Island’s innovation policy instrumentality. He thereafter entered government service to launch an investment promotion business unit at the Puerto Rico Industrial Development Company (PRIDCO). The unit quintupled the size of the aerospace industry in Puerto Rico (from 400 to 2,075 committed professional career positions) in the span of three years, including the launch of Lockheed Martin, Honeywell Aerospace and HCL Axon, as well as a major expansion by Pratt & Whitney. These successful negotiations positioned Puerto Rico as a talent source for federal innovators and added $70 million in annual payroll income to Puerto Rico’s economy. At PRIDCO, Mr. Polanco launched the “PRIDCO for Entrepreneurs” program which included funding for two technology incubators, technical assistance in winning federal Small Business Innovation Research awards, technical assistance in winning federal procurement contracts, lean manufacturing training for the aerospace supply chain, federal patent protection assistance, and commercial missions to various aerospace & federal information technology conferences.

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