Dr. Umar Saif on SCI and Startups

Saif Center of Innovation(SCI) has always been an inspiration for me. It is an excellent place  for  anybody doing a startup to dig in with inspiring entrepreneurs all around and precious advice of Dr. Umar Saif himself on regular basis.  You cannot find all this elsewhere. Following are his thoughts about SAIF Center and Entreprenuership (which should also appear in Spider magazine).

clip_image002The Science Behind Startups

We established the Saif Center of Innovation (SCI) almost a year ago, with the aim to incubate IT startups in Pakistan. Since, countless recent college graduates, students and IT professionals have approached us with queries about the modalities of a startup and entrepreneurship in Pakistan. This article answers many of the frequent queries, including the importance of a business plan, team building, pitching, funding, corporate structure and exits.

Why a Startup?

When I was at MIT, I read a report published by Bank Boston in 1997 titled “The Impact of Innovation”. This report summarized the impact MIT has had on the economy of the world. The report concluded that MIT alumni have “founded 4,000 companies, employed over a million people and had annual world sales of $232 billion. If these companies had constituted a foreign country at that time, they would have ranked 24th-largest in the world – just behind South Africa and ahead of Thailand”. The reason for this is the spirit of entrepreneurship a first grade institution in US instills in its students. Without this spirit, there would be no Google, Yahoo, Microsoft or Facebook. Its not just the wealth such startups can generate, but they have the potential to fundamentally change the game – change the way people use technology, interact with each other, live their life.

Especially for a freshly minted college graduate, a 9-5 job is most certainly not the way to change one’s life. Even a job in US that pays a “decent” $60-80K/year merely promises a comfortable living. I often challenge people looking for a job to answer a simple question: If you saved (a very optimistic) Rs. 100,000 per month from your job, how long would it take you to save one crore rupees? This simple Maths is typically enough for most people to realize that a startup is the only way they could change their life and the lives of people around them.

What Is a Startup?

In Silicon Valley, a startup typically means a group of people, mostly young, banding together to work on an innovative little product. Occasionally, this results in an HP or a Google.

In Pakistan, an IT startup often means a services-based company, which depends on outsourced projects by other companies for its revenues. Such services-based companies typically charge between $12-15 per manhour and profit from the arbitrage in the salaries paid to the local developers. Indeed, India has built almost its entire high-tech economy on this model. The largest Indian company employs more than 200,000 software developers, with annual revenues running in Billions of dollars.

Pakistan also has a large software industry based on the outsourcing model. However, unfortunately, the outsourcing model is essentially a volume game. And Pakistan’s largest software house employees 200 people, give or take a few. Clearly, it is unconceivable that a services-based company in Pakistan can scale to Billions of dollars in revenue.

Therefore, we at SCI have mostly been interested in product-based startups, since they have the potential to hit a home run and become a billion dollar company. In that, however, also lies great challenge.

For one, the model of product-based companies is not very well understood in Pakistan. There are probably a handful companies that are focused on building their own product and even fewer that succeed in this quest. Below we outline the main challenges to a product-based startup.

Business Plan

Often, in a traditional services-based outsourcing company, the business plan is simple: find outsourcing development leads and execute on a project-by-project basis. Since the end goal in such a company is the delivery of working software to a foreign client, the out sourcing company does not have to worry about the business viability or market appeal of the product.

A product-based startup, on the other hand, requires serious time and commitment planning the product, working out the financials, analyzing competitors, devising a go-to-market strategy, and refining the product in response to changes in the market landscape. Therefore, a startup must first work on a business plan.

The odd thing about business plans is that, (1) they typically change, almost drastically over time, (2) no investor actually ever looks at your 20 page business plan. So why write one?

A business plan is written by the startup team for the startup team – not for anyone else. By writing down a plan, a startup team is forced is to spell out their assumptions, carefully compare their product with competitors, work out financials, identify revenue streams and possible exit scenarios. In many ways, the process of writing, questioning and refining the business plan is typically far more important than the 10-20 page long end-product. Other than the obvious details enumerated above, there is no real template to a business plan – contrary to what most books and articles will have you believe. The primary purpose of the business plan is that at the end of writing the business plan, the startup team should have a clear roadmap ahead of them. If this is not the case, it is time to go back to the drawing board.

At the same time, it is important to emphasize the importance of at least one aspect of the business plan: Financials. In any business plan, the most amount of time is spent in understanding, computing and projecting financials. A startup is worth doing only if it is going to become a profitable business one day – and this profitability must be in black and white in your financial projections. That being said, you do not actually need an accountant to do your projections – contrary to what most books or courses will teach you, you do not really need things like Net Present Value (NPV) calculations or Discounted Cash Flow (DCF). As a start, you simply need a very detailed Profit & Loss statement including projections for the next 3-5 years. In the P&L statement, the most important thing is assumptions – clearly laid out and full accounted for in your financial model. It is important to work out the model, likely in Excel, such that you or your investor can easily change the assumptions and see its effect ripple through in your projections – on other works, parameterize your financial model with your assumptions. These parameters include assumptions on hiring staff, volume of sales, expenses, pricing models and customer acquisitions. Indeed, every startup first makes the best-case model – and can’t be blamed for the optimistic enthusiasm – but a parameterized model enables one to change the assumptions and quickly see the financials for less-than-best and worst case scenarios.

Team

Having explained the business plan, it must be emphasized that the importance of a business plan is typically overstated. Business plans invariably change and often quite drastically – and they should. Markets change, competitors crop up and products evolve – this is a natural cycle that every successful company goes through. Therefore, in a startup, the most important thing is not a business plan, cast in stone, but a team of people willing to execute, revise and refine the plan when the rubber meets the road.

The importance of team for the success of a startup, therefore, cannot be exaggerated. You can have the best idea in the world and fail because of a weak team. You can start with a half-baked plan and succeed because of a stellar team. It is often said in the Venture Capital (explained later) world that investors do not bet on horses, they bet on jockeys. That is, an investor typically does not invest in a business, they invest in the team that is going to execute the plan.

In my experience of incubating companies at SCI, I have a simple conclusion: A startup will fail or succeed solely based on the level of motivation, hard work and perseverance of its team. There is no other secret sauce. Period.

Building a great team is very difficult. One of my mentors told me once that the assured way to succeed is to surround yourself with people who are better than you. As a founder of a startup, you must hire people who are better than you. I have seen that most teams find it that very difficult to follow that advice. The natural tendency is to hire people who one can easily control and influence – people who look up to you and, hence, are not better than you. But remember, as Steve Jobs said, A class people hire A class people, B class people hire C class people and C class companies do not succeed.

As a parting thought, a misnomer that most articles and books help advance is the absolute necessity of an MBA in a startup team. You do not need an MBA, but you most certainly need someone in your team with a good business sense. It is important that everyone in the team has complimenting skills – most important of which is the skill to sell your product and manage your team. I would not go so far as to begrudge an MBA on a team, but remember that most people out of business school choose to become investment bankers and high paying executives, not fledging entrepreneurs.

Funding

As a product-based company, a startup has to spend a significant time building and refining its product. This means living the first several months in the life of a startup without any incoming cash flow. As a side, this is also the reason why most “startups” in Pakistan are simply outsourcing software houses – with a paying client to start with, such companies have the economics to become cash flow positive from the start.

For a product-based company, it is important to build the product without any revenue stream. If you are a startup like AMD or YouTube, you can find yourself spending hundreds of millions of dollars to build and sustain a product before you start seeing any revenue. A startup can have this luxury only once it has sufficient funding to support its early years of development. And that is not enough, a startup needs capital that is both patient and understands the risks. For instance, a loan from a bank is distinctly unattractive. Above all, a bank in Pakistan (and elsewhere) will lend money only against some collateral. Most geeky founders do not have the kind of collateral banks are used to in Pakistan. Unless you want to pledge your house. And for a startup, this may not be a good idea since a vast majority of tech startups fail. Inventing something new and making it profitable is a risky business — and the funding source has to understand and accept this risk.

When entrepreneurs in US faced this challenge a couple of decades ago, it led to a new class of funding source: Venture Capital (or VC). Venture Capital is money that you do not have to return. Instead, a Venture Capitalist takes equity (share) of your business in return for the investment. Depending on how early or late a startup seeks venture funding dictates the share taken by the investor. Venture Capital has many advantages. Above all, it facilitates product-oriented startups by freeing a company from worries of profitability early on. More importantly, by focusing on creating value for the investor, rather than earning enough to pay back the capital and an interest rate, founders can be bold, innovative and ambitious in attempting to hit a home run. Failing also becomes less painful – encouraging bold innovation and the ambition to swing for the fence. Since a VC is investing in a business and risking its capital, VCs are known to contribute more than money by helping with the management and growth of the business. In most cases, VC funding often brings some corporate structure to a startup.

However, in a country like Pakistan, there is no Venture Capital fund. Unfortunately, given the difficult times Pakistan is going through, few foreign VCs want to invest in a Pakistani startup. So where does it leave us? This is a difficult question, and perhaps the biggest challenge for product-based startups in Pakistan. One option is to ask friends and family for money, in return for equity in your business. This is so common that in US there is a name for this funding round: Friend-and-Family round (though given the risk involved, this is also often dubbed the Friend-Family-and-Fools round). The other option is to bootstrap – fund the startup yourself. The good news is that most IT startups require very little cash (unless you want to invent a multicore chip to challenge Intel). As Paul Graham puts it, “The main cost of starting a Web-based startup is food and rent. Which means it doesn’t cost much more to start a company than to be a total slacker. You can probably start a startup on ten thousand dollars of seed funding, if you’re prepared to live on ramen”. Indeed, Hewlett and Packard started in their own garage and even saved on rent – so can you! An IT startup typically does, and perhaps should, takes 3-4 very driven guys (or girls) working in a small room with some second-hand bargain computers and churning our the next Google. After all, that is how Google was also started, and Yahoo — and Apple ..

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For companies that require more cash, a startup can certainly look for angel investors: wealthy investors willing to invest between Rs. 1 to 10 million rupees in a startup. Given the state of real estate and stock market in Pakistan, I have found that more and more people are willing to explore investments in non-traditional assets such as an IT startup. Finally, there are incubators like our Saif Center of Innovation (SCI – http://www.saifcenter.com ) that give startups space, investment, and corporate management to succeed in its early years.

The Business

In order to succeed, a startup must one day become a successful business. It must become a legal entity, such as a Private Limited Company in Pakistan, maintain its accounts, have a board of directors and stock-holders. I have found that it is best to involve a lawyer when incorporating an entity. At times, it is also advisable to start with a simple partnership deed between the co-founders and defer incorporation to a point when it is necessary. That being said, company law in Pakistan is weak on valuation of IT startups since such a company does not have traditional assets. We still have not found a legally sound way to value software as an asset in Pakistan! The best way is to register a partnership and have it acquired later by a private limited company with the desired valuation.

I have also found that most co-founders face a trust deficit in the beginning. There is no easy way to overcome this, than to have some faith – and choose well! If a partnership goes sore, there must be enough legal paperwork in place to gracefully split the assets, brand value and customers between co-founders. All such things should be carefully spelled out in the legal paper work for a rainy day. For instance, it is important to write down who will own the brand name in case the company is wound-up. In an IT startup, the brand name often has significant value. I also encourage co-founders to agree on a vesting schedule, such that the stock of a co-founder only vests over time. This means that co-founders are both shackled in golden handcuffs to work together in the early years, and also have an exit put in place when a co-founder decides to move on. Typically a vesting schedule of 2 years is a good rule of thumb.

Concluding Advice

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Remember that almost no entrepreneur or startup succeeds in its first attempt. Therefore, often the magic to success in the IT startup world is determination to succeed. As Paul Graham states so aptly: “In most domains, talent is overrated compared to determination—partly because it makes a better story, partly because it gives onlookers an excuse for being lazy, and partly because after a while determination starts to look like talent”. So working hard, longer than anyone typically anticipates, is the key to a successful startup.

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