With Michael Palumbo, trader, entrepreneur, venture capitalist, and author of Calculated Risk: The Modern Entrepreneur’s Handbook
Michael Palumbo And The Modern Entrepreneur’s Handbook
Steve welcomes guest Michael Palumbo to today’s show. Palumbo has been variously a trader, a venture capitalist, an entrepreneur, and an author. He recently published a fascinating, useful, and concise book entitled Calculated Risk: The Modern Entrepreneur’s Handbook. Michael’s impressive resume includes, among other accomplishments, launching Third Millennium Trading at the Chicago Board of Options Exchange, a company he started for $250,000 which was valued at $100 million just 10 years later. He also found success as an angel investor in a financial tech startup which grew to a $1.7 billion-dollar business. Michael joins Steve today to talk about what makes successful companies thrive while their competitors fade, checklists that entrepreneurs launching new companies should consider (as well as the investors evaluating them) and how entrepreneurs can value their own companies the way that venture capitalists do.
New Company Checklists
The conversation begins with a discussion of some of the aforementioned checklists which Michael believes can help entrepreneurs and investors better understand a company’s prospects. These checklists apply both to the value of the core idea or ideas underpinning the business (its main products or services) and also to the execution of a plan to bring these ideas to market. The first checklist is the “geography test,” which looks at the chances that an idea will be likable and find a larger audience of potential buyers beyond the company’s local market. It’s a fairly simple test that attempts to assess whether an idea is going to catch on and help the company grow. Steve asks Michael to give an example of a company that started small and then realized its potential for “scalability” and executed on that. Michael opines that Amazon is a perfect example of this kind of company and marvels that they have grown from a bookseller to become the largest retailer in the world.
The next checklist has to do with “feasibility,” which Michael explains as having to do with the question of whether current technology can provide support for the product and enable it to sell. This leads to some interesting speculations about internet companies from the late 90s that did not survive the tech bust of 2000. Michael asserts that some of these companies had solid ideas but were simply too early in their entrance to consumer markets. Because dial-up internet was far slower in those days, creating a compelling user experience on the web based on their ideas was simply impossible. It’s fascinating to think of how some notorious failed “web 1.0” companies might have become great successes if they had only waited 5 or 6 years before launching. This thought experiment illustrates the principle of feasibility and the dangers of mismatches between great ideas and the technological environments needed to realize them.
People More Important Than Ideas: Management And Sales
Demonstrating his background as a venture capitalist with expertise at evaluating startups, Michael makes a compelling case that the founders, management, and sales talent at new companies deserve to be treated as critical checklists of their own. By way of example, he mentions the “video wars” between two competing formats: VHS and Betamax. While Sony’s Betamax had a better-quality product, it was JVC’s VHS format which won out and enjoyed the spoils of a major revolution in mass market consumer technology. Michael attributes this to JVC’s superior management team and sales strategy. JVC moved quickly to make distribution deals with movie producers while Sony was complacent and overconfident that its better product would bail them out. JVC’s aggressiveness paid off so well and so quickly in part because a global market of movie fans was ready to embrace whatever platform delivered the movies they wanted to see. The lessons that Michael takes away from this are that company founders and managers need sales talent even more than they need inventor talent. He harps on this repeatedly in Calculated Risk because he’s convinced that sales is a kind of skill set or talent that too many entrepreneurs lack, and, worse, fail to understand the critical importance of. He believes that a good-if-not-outstanding idea along with basic feasibility can conquer markets if the company’s people—its managers, founders, and sales teams—are excellent.
Discounted Cash Flow Valuation For Startups
The second half of Steve’s and Michael’s conversation dives into somewhat more technical aspects of valuing companies’ potential, especially as it relates to capital investments. Michael observes that most entrepreneurs have difficulty evaluating the longer-term worth of their ideas and businesses, something that Venture Capitalists are quite good at. He believes this blind spot puts them at a serious disadvantage when it comes to understanding and negotiating investment offers. His solution is “discounted cash flow valuation”, a common method in financing to project future earnings. Michael devotes a chapter to the math and numbers involved because he believes it’s critical for entrepreneurs to gain literacy in an approach which is certainly being used by the Venture Capitalists they may want to cut deals with. He illustrates this by describing a decision he made in the early days of his company, Third Millennium Trading, to decline an offer of $1M dollars for a 50% stake in his company. Using estimates and projections in a discounted cash flow valuation, he was able to determine to his own satisfaction that his company would be worth at least $9M. It turned out to be more valuable than that by a factor of more than 10. When it comes to capital fundraising for startups, having a ballpark number to express your future earnings potential may make the difference between sinking or swimming—or keeping a mere fraction of the money that you otherwise might have kept.
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Steve Pomeranz: Michael J. Palumbo is a trader, entrepreneur, and venture capitalist. He launched Third Millennium Trading at the Chicago Board of Options Exchange, and, in less than 10 years, his $250,000 investment was worth in excess of $100 million. He then became the angel investor in a financial technology firm and exited when the startup was valued at over $1.7 billion. He joins me right now to talk about his new book, Calculated Risk: The Modern Entrepreneur’s Handbook. Michael Palumbo, welcome to the show.
Michael Palumbo: Hello, Steve. Thanks for having me on.
Steve Pomeranz: Hey, Mike. You know, this book is a handbook of sorts for entrepreneurs. It’s a small book, but it’s packed with lots of really good, easy to understand information. One thing you do is you show us how to consider the viability of a new idea as well as the execution of that idea. I mean, it’s one thing to have a great idea; it’s another thing to figure out whether it’s going to be successful—and, then, of course, execute it. You list kind of like, checklists to start a new company. The first thing that you mention in testing an idea is geography. Tell us about that.
Michael Palumbo: Well, I think that’s a great way to look at whether the idea is going to catch on well or not. We call it the geography test. Geography test is basically just looking at how wide the likeability of the product is going to be geographically. Are you going to appeal to people in one small area, or is it going to be more of a product that works with a lot of different people? Obviously, the bigger the better because it’ll be easier to catch on and it’ll obviously be easier for growth. That’s one of the tests we use.
Steve Pomeranz: Yeah, so is it scalable? Can you take what you’re doing right now and make it much bigger without having to spend tremendous amounts of capital in order to do that? What are some examples of companies that started out next to nothing and had this tremendous scalability?
Michael Palumbo: Well, we talk about a few of them in the book, but I’ll tell you the best one that I can think of is Amazon. Amazon started out just selling books, basically. Now they’ve become the world’s best retailer in terms of volume, in terms of sales. That’s by far the greatest example of a company that started out small, but they realized that what they were doing is, as you say, scalable in a way where it can be just about any product, any retail product. Now, you go on Amazon, you can buy anything.
Steve Pomeranz: Exactly, exactly. Another checklist item to look at is what you call feasibility. When you say feasibility, what are you speaking about?
Michael Palumbo: Yeah. That’s a $5 word. Let me just make it simple here. We can call it feasibility, but, really, will it work given the current environment for technology? Even more so, when you have an idea you’re maybe trying to look a couple years out, will the technology be there to be able to make this, we call it, feasible, or make the product be able to be sold? We give some good examples there again. We go back to the .com era, and I talk about some of the companies like eToys, pets.com…there were some companies that had what were good ideas on paper, but they were not executable. They were not able to be done …
Steve Pomeranz: Why?
Michael Palumbo: …Based on the current …well, based on the current technology at the time, they were companies that depended on a very fast internet connection. Things that we take for granted now. Right?
Steve Pomeranz: Mm-hmm (affirmative).
Michael Palumbo: If they were launched a few years ago instead of say, 1998, then it would, basically, have been probably a success. A lot of the online retailers now that have the same ideas as those companies back then, they’ve done well. The problem was…is…that at the time. those ideas were not feasible because there were not fast internet connections. It was slow. It was not as enjoyable-
Steve Pomeranz: It was dial-up. A lot of it was dial-up back then. Right?
Michael Palumbo: Exactly.
Steve Pomeranz: It was interminable, and then you didn’t really … Paying online was an issue. It was hard to do.
Michael Palumbo: Impossible, yeah.
Steve Pomeranz: You can have a great idea, but the timing or the technology might not be ready for your idea.
Michael Palumbo: That’s exactly what we go through with the book. The key here is that the idea could be great, but it also has to be timed right, as well, both in terms of technology and also is the marketplace ready for that type of idea. It’s funny because a lot of those companies that failed in the end of the ’90s, early 2000s in the tech bust, those companies might have done fine right now because the technology is so much better.
Steve Pomeranz: Yeah. It’s funny that we really haven’t seen them. I mean, maybe they’re out there and I just don’t know about them. I don’t know of an eToys or others like that.
Michael Palumbo: You know what? There are some. Let me real quickly…
Steve Pomeranz: Sure, go ahead.
Michael Palumbo: Gilt is a good one. That’s a company that basically is all online. There are definitely some retailers that started just to work online. What’s happened, really, is that the retailers, the big box retailers, have been forced to go online to compete with the Amazons. That’s what actually happened, is once the technology started to become available, the big box retailers went online, even Best Buy and companies like that, because they had to. Instead of the eToys and the ones that just were online, you find most of the online things that are happening right now are basically companies that started off as brick and mortar companies.
Steve Pomeranz: Maybe one reason is that they have this deep …brick and mortar companies have been in business for so long…they have these deep benches of management. One of the key terms or aspects that you look for is management competency. I use the great example of VHS tapes for those of us who are old enough to remember them, versus Betamax. Betamax was a competing tape manufacturer or platform, and it was actually superior to the VHS, but VHS won because of management incompetence on the part of Betamax. Tell us about that.
Michael Palumbo: Yeah. They just didn’t market the product correctly. It just comes down to sometimes the best ideas don’t win. It’s amazing that we use that as an example. It’s such a great example of the fact that there was better technology in Betamax, but because they didn’t market it and get the word out to users and to companies that would be putting their products, or basically their films, out on that method, they were actually beat by an inferior technology. People that look back on that that really maybe didn’t pay that much attention or there are younger people out there that didn’t live through that era, they just hear of Betamax and think that it must have been inferior, that it just … no. What happened was management was inferior. Just as important as the idea is, in fact, probably more important really, is that the founders have to know what they’re doing. They have to be able to bring that product to market correctly. That’s an important aspect, probably more important than the idea itself.
Steve Pomeranz: Well, you mentioned that Sony made the Betamax, and, what was it, JVC made the VHS?
Michael Palumbo: Yeah.
Steve Pomeranz: JVC went right to the film producers and had more films put on the VHS tapes, so the consumer got to recognize that more than the Betamax, even though the quality of the picture was better. Pretty smart stuff.
Michael Palumbo: Exactly. That just basically shows that management has…or founders, however you want to word it … basically, they are just as important to the success of a startup. You can really make some bad mistakes in marketing your product and cost yourself the ability to gain market share, even with a superior product. It’s very important to make sure that you’re a good salesman and not just a good inventor. If you are not a good salesman, it’s important to find someone as a partner that is. We talk about this in the book as well where, when you start a company, you look at your own skill set, and it’s important for you to evaluate what you’re good at and what you’re not good at. If you’re not good at something you need to find—especially sales—that’s, like, the most important part of starting a company. You have to be a good salesman. If you don’t have those skills then you need to find someone that does.
Steve Pomeranz: You know, you’re talking about sales skills. By the way, the book is Calculated Risk: The Modern Entrepreneur’s Handbook. My guest is Michael Palumbo, a successful entrepreneur himself. Let’s talk about raising money. Raising money is really, really difficult. You say even for great sales people raising money is very, very frustrating, time-consuming, and difficult. Why is that?
Michael Palumbo: Because it’s something that, generally, when you start a company, you’ve never had to do anything like that before in your life. Raising money, you have to be able to sell your idea to very sophisticated investors. First of all, most entrepreneurs don’t really have a skill set that makes them good at this. A lot of people that think of great ideas, a lot of great idea people, as I’d said, are not great salesmen. This is just a difficult thing to do for most entrepreneurs. We talk about some of the things that VCs look for in a company, but I’ll tell you what. As a VC myself, what I look for number one is the quality of the management or the quality of the founders. I think that’s more important than the idea because I look at a Steve Jobs, some of the great entrepreneurs in history, Henry Ford, and Bill Gates, these guys, they could sell ice to Eskimos. I’ll tell you what. You find the right people, and as long as the idea is a reasonably good idea and can pass the basic tests that I talk about as far as feasibility, et cetera, then you really look at the people.
Steve Pomeranz: Interesting.
Michael Palumbo: Can they execute?
Steve Pomeranz: Well, one of the characteristics that you mention in your book is that for a company looking to find money or to raise money for their business, that they should choose their investors. You gave a list of items that they should be looking for in the investor that they’re going to basically be partnering with. One, as you mentioned, was good people. One was fair terms and pricing, and I want to talk about this for a minute. So many entrepreneurs—you watch Shark Tank—people don’t really know how to value their own business. There’s always that tension between the panel and the presenter as to what they think the business is worth. You really do give a good tutorial in your book about valuing your business properly. Give us some ideas based upon your own business, how you were …at one time, you had a need for money and you were offered a million dollars for a large percentage of your company. I guess you turned it down because you did the math. Tell us about that.
Michael Palumbo: Yeah. This is a great example. You know, you bring up Shark Tank. I love that show because it really does show would-be entrepreneurs what it’s like to go in front of VCs. It’s a great example of the fact that VCs generally know how to value a business better than the entrepreneurs. You get a guy like Mark Cuban, and these guys are sophisticated investors. They understand what these people’s companies are worth better than the people that started the companies. It’s just because the entrepreneurs, they’re idea people. They have these ideas and they have these goals and they have these great possibilities, but they don’t really understand what it’s worth. A lot of times, as you said, there’s a big gap between what the entrepreneur thinks that the company’s worth and what a VC who’s more sophisticated would value it at.
In my own life, what happened was it was an early time in my company’s existence, and it was the only time that I was thinking about taking in some outside capital. I went to a—you would call him a VC back then—an investor that was interested. He was offering me a million dollars to help the company grow faster for half the company. The problem is, and I was more of a sophisticated investor than most entrepreneurs because I’m in the trading industry, so I kind of understood it a little bit better than some people. I turned it down because what he was asking for was, basically, the value of my company at $2 million. I mean, if he’s going to pay a million dollars for half the company, that means the whole company’s worth $2 million. To me, even though we were young, we had huge growth potential, and I thought the company was worth much more than that. Now, you do find entrepreneurs that have a pie in the sky valuation on their company that’s not reasonable, but, in this case, I was very confident that this person was underpaying for what he was getting, and so I turned it down.
Steve Pomeranz: Well, you were able to try to make some growth projections of your revenues and your earnings, and then discount them back to present value using discounted cash flow model. You were able to see that, at least, in this one valuation that your company was worth $9 million.
Michael Palumbo: Right.
Steve Pomeranz: A million dollars, maybe you could have offered him 1/9 of the company or maybe 20% of the company or something.
Michael Palumbo: Exactly. We talk about this in the book. There’s a great method to value companies called discounted cash flow. It is something I think entrepreneurs should at least have a grasp of. That’s why I put it in the book. It’s a lot of numbers; it’s a lot of math. It’s a chapter in the book that’s important because, if you understand that, then you can speak the same language as these VCs do. The VCs all understand this kind of cash flow. They all understand that type of thing, and entrepreneurs generally don’t. I was able to, yes, use discounted cash flow methods to project my earnings into the future and say, you know what, this guy wants 50% of the company and is willing to pay a number that’s probably only as you said, about 1/9 of the company. Because he would have been coming in and helping us grow faster, I probably would have sold for 15-20% of the company just because he would have helped me grow faster and that does help your valuation. We go through that in the book as well. The bottom line was he was nowhere near the value that I thought the company was worth. Again, using discounted cash flow, you can kind of figure that out, at least a good estimate. It gives you a ballpark because you’re always still based on what your projection is. Your projection could be off.
Steve Pomeranz: That’s true. Absolutely.
Michael Palumbo: Yeah. I just knew that based on that he was so far off that even if my projections were a little bit off, he was still nowhere near what it should have been.
Steve Pomeranz: Well, the key is you got to know your number. It’s the old saying that if you’re sitting at a table playing poker and you’re wondering who the patsy is, you’re the patsy. They know their number. They should know your number. You should know your number. If you don’t know your number, you’re going to lose that gain. That’s a life’s worth of work that you’re not going to really want to lose. Hey, unfortunately, we are out of time. My guest, Michael Palumbo, the book Calculated Risk: The Modern Entrepreneur’s Handbook. Thank you so much for joining me, Mike.
Michael Palumbo: Hey, Steve could I say how they can get the book?
Steve Pomeranz: Sure, absolutely. Go ahead.
Michael Palumbo: Sure. The website’s just called calculatedriskbook.com. It’s all one word, and they can get the book there. Then they can follow me on Twitter @Mikepal10. It’s M-I-K-E-P-A-L-1-0. I just talk a lot about entrepreneurship …
Steve Pomeranz: Wonderful.
Michael Palumbo: … And a lot about the stock market.
Steve Pomeranz: Great, great. Wonderful. Thanks for joining us, Mike.
Michael Palumbo: Thanks. It’s been a pleasure, Steve.