Running a PAYE Scheme with Gnucash

If you're a startup then you're unlikely to want to pay for a commercial accounting package. One option is to use the free Gnucash application, which is an excellent open source, double-entry accounting package. However, trying to run a UK Pay As You Earn (PAYE) scheme for your employees using Gnucash was not, at least for me (!), totally obvious. Here's how I ended up solving this particular problem.

Background

For those not familiar with UK PAYE schemes, the basic idea is that the employer deducts income tax and National Insurance Contributions (NICs, similar to Social Security in other countries) "at source". The result is that an employee's gross salary has these deductions made to it, and they are paid the net salary, thus meaning that most employees do not need to make tax declarations at the end of the financial year. In addition to NICs made by employees, employers also contribute NICs (at a rate of 11% of the gross salary).

Accounts Needed

Gnucash works on the principle that expenses, liabilities, assets and income are all split into different accounts. For keeping track of a PAYE scheme, here are the accounts that I use:

• Expenses:Payroll Expenses (you probably already have one of these as it's a default Gnucash account). This will keep a running total of only the net salary that you pay employees, i.e. it excludes the income tax that you as an employer deduct from the employee's gross salary, the employee National Insurance Contributions (NICs) that you also deduct, and the employer NICs (extra, on top of gross salary).
• Expenses:Income Tax, Expenses:Employees' NICs, Expenses:Employer's NICs. These enable you to keep track of how much each of these have cost the company.
• Liabilities:Income Tax Payable, Liabilities:Employees' NICs Payable, Employer's NICs Payable. These keep a running total of how much of each type of tax the company currently owes HMRC.

Recording an Employee's Hours

Depending on how your scheme is set up, you may pay your employees by the hour, or per week or month. I (mis)use Gnucash's concept of an "Expense Voucher" to record these. When you wish to record the employee's hours, simply create a new voucher ("Business", "Employee", "New Expense Voucher"). Make four entries in the voucher, one each for the income tax, two types of NICs, and of course the net salary. The expense accounts for each of these are those detailed above (i.e. Expenses:Payroll Expenses, Expenses:Income Tax, etc.). The liability account for this will be the default Liabilities:Accounts Payable, as none of these amounts have actually been paid yet. Post the voucher to the accounts ledger in the normal way, with a due date of the end of the month (or whenever you pay your employees).

(Note: in order to calculate the amount of tax and NICs due, you'll either need to calculate it manually, or use the tools on HMRC's Employer CD-ROM.)

Paying an Employee

When the end of the month comes (or whatever period you use), the expenses vouchers will pop up in the bills due dialogue. With "normal" bills, you would "Process Payment", and pay the full amount. Under this scheme, it's a little more complicated: you need to process each voucher four times (sorry!).

The first time you pay the employee their net salary, so enter that number into the amount field of the "Process Payment" dialogue box. The account that the money is transferred from is likely to be your Current Assets:Checking Account, as you'll be giving them actual money on their payday.

The second time you process payment you'll "pay" the income tax. The transfer account should now be your Liabilities:Income Tax Payable account, as you're simply transferring a liability from your general "unpaid bills" account to the specific one for income tax that you owe to HMRC (and pay on a different timescale to your employees: potentially you may only pay HMRC quarterly if you have a small wage bill).

The third and fourth times are used to similarly transfer liability for the employees' and employer's NICs to their respective liability accounts.

You should now have ended up with four entries in your Liabilities:Accounts Payable account, which reduce the balance by the total of the original expense voucher that you used to record the employee's hours.

Paying HMRC

Each month or quarter, you'll need to pay HMRC the NICs and income tax that you have deducted. All this involves is looking at the balance of each of Liabilities:Income Tax Payable, Liabilities:Employer's NICs Payable, and Liabilities:Employees' NICs Payable, and making a transfer from your Current Assets:Checking Account to each of them to zero the balances. Evidently these transfers from your checking account should in reality be going to HMRC.

Note: one thing that caught me out recently was being too efficient, and paying HMRC too early (!). One company I'm involved with makes quarterly returns, i.e. we don't pay NICs/income tax every month. I transferred the amount for the quarter ended July 5th at the end of June. Later I received letters about how they hadn't received the July payment... Turns out that if you pay before the date the quarter ends, they assume that the payment must be for the preivous month... You have been warned!

Conclusion

It's not an ideal system (processing the same voucher four times is a pain!), but it does mean that every number ends up in the correct account. If anyone has any good suggestions on how to make this process better, please comment!

(Note: Having been silent over the summer, mainly down to starting a new job, I'll now hopefully return to a more productive autumn as regards blogging!)

What Tasks Need to be Completed When Starting a Limited Company?

Having helped start two companies, another that I'm involved in is soon to incorporate. Here, I'll list the various steps you need to go through when setting up a new private limited company, in the United Kingdom.

Register with Companies House

Companies House has the details of all companies trading in the UK. This includes details of directors and shareholders, as well as financial information (accounts). Incorporation involves filing the relevant form, together with a small fee, with the Registrar of Companies. The snag is that the form needs to have the signature of a witness that is deemed "official". This boils down to needing a lawyer to watch you put pen to paper. Instead of the hassle and expense of doing this, you can either buy a ready-made company from one of the many firms offering them, or use an electronic incorporation service. In the latter, the service acts as the witness, and files your incorporation forms for you. The fee over and above Companies House's own can be as little as £5, and it's worth shopping around. The list of companies offering electronic incorporation services is on Companies House's web site. Note that all such firms will try to sell you all sorts of other services (e.g. doing your accounts for you, running your web site). You only need them to submit your Form 10 and Form 12 to Companies House, and send you back electronic versions of your company documents.

Companies House has a vast amount of guidance on the intricacies of incorporating, and running, a company. Take the time to read it, particularly the Guidance on Company Formation.

Register for Electronic Filing

Whenever you need to change the address of any director or the company secretary, or file the annual return, Companies House allows you to do this electronically using their WebFiling service. You can also opt for their PROOF scheme, in order that they will only accept documents electronically rather than also by post. This has the advantage that it is much faster, and also more secure, as it prevents random people sending in false changes of address for your company. Registration for WebFiling necessitates asking Companies House to send you an activation code through the post, whilst PROOF also requires you to send them a paper form.

Register as an Employer

Company directors are required to fill in an Employment page in their self-assessment tax returns for each company they are director of. HMRC tell me that this applies even if the director did not actually earn anything, which implies that as soon as a company incorporates, it has employees in the form of its directors. (Note that this conflicts with the idea expressed in the "When You Need to Register" (as an employer) section of HMRC's guidance, which implies that if employees are not paid very much, registration is not necessary).

In order to be an employer, the company must register as such with HMRC, and can use their Send New Employer Details by E-mail tool (provided that the company has fewer than 9 directors, and does not operate a "simplified" PAYE scheme with more than 10 employees. If so, register by telephone).

Within a few days, your accounts office reference and PAYE (Pay As You Earn) reference numbers will come by post. These are needed when filling in PAYE forms, and by your directors for their tax returns.

Register for PAYE Online Services

Having obtained your PAYE reference, you can now register for using HMRC's PAYE online tools. These make life easy as regards keeping track of employee data, and submitting forms (e.g. when you take someone on, or submitting P14s at the end of the tax year).

Registration for online PAYE services requires you to create a Government Gateway ID and password, which is sent to you in the post, along with an activation code. You'll then be able to tell HMRC that you're employing your directors.

Inform HMRC that PAY/NICs Contributions will be Nil

If you will not be paying your directors anything (in cash or any other benefit), you are unlikely to owe HMRC income tax or Class I NICs (National Insurance Contributions). Normally, such payments to HMRC are made monthly, or quarterly for small businesses. However, you can inform HMRC that your returns will be "nil returns" for the foreseeable future, which will remove the requirement on you to keep sending these in. For the telephone number for this, see the No PAYE/NICs Payment Due page. You can also use the form on that page to send in nil returns for any months/quarters where you do not owe any PAYE/NICs, but have not notified HMRC that you will be making nil returns for an extended period of time.

Take Out Employers' Liability Insurance

If you are intending to pay your employees anything at all, you are almost certain to be legally required to take out employers' liability insurance. Take a look at my post Do You Need Employers' Liability Insurance? for more information on this.

Register for Corporation Tax Online

Soon after your first year of trading you'll receive a Corporation Tax return in the post from HMRC. You can also file this online (which makes life easy, as the paper form covers many cases which are unlikely to apply to you), but have to register to do so. You can only do this when you receive your UTR (Universal Tax Reference) number, and hence probably won't be able to do so at the time you register for PAYE online. Oh well... See Corporation Tax online registration (fortunately, you can use the same Government Gateway ID as for PAYE online).

Conclusions

If you've managed all of the above, congratulations! All you now have to do is survive your first annual return from Companies House (where you detail who the shareholders are), and file your accounts with them (which also need to be filed with HMRC).

If all of this fills you with fear, an accountant will be able to help, but of course they'll charge you money. If you're a start-up in Cambridge who needs someone on board to help navigate through the waters of legal and financial bureaucracy, I'm job hunting!

Do leave any questions/comments and I'll try to address them in a future post.

Do You Need Employers' Liability Insurance?

I'm involved with three companies: N-Sim, a software consultancy, Accuvex, a holding company, and Verieda, which works on EDA tools. When each of them has been started, the same question has gone through my head: "do we need to take out employers' liability insurance?".

Employers' liability insurance, or ELI for short, is normally required by law in order to protect your employees. For example, if an employee on a building site falls from some scaffolding, (hopefully!) the company's ELI will pay out. In the United Kingdom, the minimum cover is £5 million, and most policies offer cover of £10 million.

For many companies, the question of "do I employ anyone?" has an obvious answer. Construction workers are a case in point. However, when it comes to software companies, it might not be such an easy question. "Surely", the argument goes, "I don't need ELI if I don't employ anyone, if all my work is done by contractors?".

Exemptions from ELI

The UK Health & Safety Executive have a guide to ELI for employers, which describes what exemptions there are. In particular the following are exempt:

• Most public organisations (government departments, police...), and health bodies.
• Family businesses where all employees are closely related to the owner (but not when the business is a limited company).
• Companies which only employ their owner, where that owner owns 50% or more of the issued share capital.

I'll assume that we're dealing with a private limited company, probably writing software, and hence that the first two exemptions aren't relevant. The 2004 amendment to the 1969 Employers' Liability (Compulsory Insurance) Act allows only for a company with a single employee (who fulfills the 50% criterion above) to be exempt. Hence, two directors who split the equity equally and are employees are not exempt.

That's fine, but what about companies with unequal shareholdings, or more than two directors, or with contractors? Who counts as an employee?

Who's an Employee?

For income tax purposes, directors of limited companies are treated as employees, and hence fill in the "Employment" pages of their self-assessment tax return. In most cases, this is reasonable, since the directors are likely to be deriving benefit (salary or dividends) from their work, and moreover are essential (difficult to replace) in the company's normal function. They cannot subcontract their responsibilities, nor (generally) do they provide their own tools for doing the job. All of these aspects are some of the tests of whether someone is employed by the company, or a self-employed contractor.

On the face of it, then, companies that employ more than one director need ELI.

However, the HSE's guide to ELI for employers also says that "you may not need [ELI] for people who work for you, where they do not work exclusively for you". Clearly, this is relevant when a contractor performs some work for the company, but also carries out similar work for other entities. It is important to note that the HSE's definition of who is an employee is distinct from HMRC's (Revenue & Customs) definition: someone's tax arrangements may mean they are defined as self-employed, but from an ELI perspective, they may be an employee. I'm going to assume that this provision does not apply to part-time employees of your business, who have another job. It's unclear, though.

Of course, if you're a start-up company, and you don't pay your directors anything, then they don't count as employees for ELI (see HSE's guide to ELI for employers again), but the company can still be held liable in case of a claim for compensation, so taking out ELI might still be wise. Hence, one exemption might be to have a director, who owns a majority shareholding, being an employee, whilst having another person helping you out, who is unpaid. Bad luck for the unpaid person...

So Who Does Need Employers' Liability Insurance?

If you're a one-person band (with a majority shareholding), and only use contractors (who satisfy HSE's tests for not being employees, rather than just having self-assessment status for tax purposes), you're likely to be exempt. In any other case, you're not.

Which brings us to an interesting conclusion: if two friends start-up a limited company that sells shareware software, both of them being directors with 50% holdings, and carrying out part-time work for the company for which they are paid, say, £10 a month (it's a small company!), it seems that they need ELI. This is despite the fact that they are both directors, working from home, earning tiny amounts, and would be stupid to sue themselves. Perhaps this is one reason that such small companies shouldn't bother incorporating.

Having said that, note that if you have a limited company that is not paying its directors (e.g. because it's just starting up, or is dormant), it appears that ELI is not necessary.

(Note though, that if you're a director, when you want to fill in your tax return, you'll need an "employer's PAYE reference". This can only obtain by registering the company as an employer with HMRC. And then not paying yourself anything to avoid needing ELI. Oh well...)

But ELI Costs Too Much!

It's definitely worth shopping around: different insurers quoted us wildly disparate premiums. Policies tend to be based on how large the company's wage bill is, hence the premium doesn't have to be unmanageable. Different companies will have different minima for such total wage bills (one reason for shopping around). At present, N-Sim uses Zurich Insurance, who meet our needs well, though they do include (for free) a public liability insurance that does not cover our main line of business which is selling software consulting services. Nevermind...

Update (21/04/2009): Just found the statistic that around 210,000 SMEs in the UK do not have ELI. Not really a surprise, given the costs and how one could easily think "we're friends, we won't sue each other"...

How to Value an Investor's Stake

I'm currently looking at a draft version of an entrepreneurship course written by, among others, people from Cambridge's Judge Institute, and hosted by Epigeum. Something that I found particularly helpful was how to decide what percentage of a company to sell to an investor for the particular amount of money the company needs. I've summarised it here.

The Value of a Stake

If the company is seeking capital worth c, then the issue is to calculate s, the percentage of the equity that should go to the investor providing that capital.

Firstly, assuming this is venture capital, the investor will look to exit probably within five years. Call this number of years y. Let r be the amortised annual rate of return that they desire, say 45%.

Hence, we can say that when the business is sold after those y years, the investor's stake should be worth w = c(1 + r)^y, as this provides the desired rate of return.

Therefore, the stake is simply the fraction that w is of the selling price (market value), p, of the business. Of course, how does one estimate p?

The answer lies in using the Price/Earnings (PE) ratio for a similar, established, company, which details their worth as compared to their sales. Assuming that we can predict the likely earnings of the company in y years' time, then we can multiply this by the PE ratio in order to obtain p.

Investors may well discount the PE ratio, either because they do not believe it to be realistic, or because of the perceived risk, or because the expected revenue is uncertain.

As an example, assume a £1 million investment is needed, that r = 45%, and y = 5. This means that w = £6.4 million. If projected sales in year 5 are £1 million, with a PE ratio of 15, p = £15 million. Thus, the initial stake would be 6.4/15 or 43%.

Which is food for thought. It does very clearly show how VC investors "need" to take very large equity stakes in order to make the desired rates of return. Hardly surprising, but it's nice to at least vaguely understand the mathematics behind it all.

Understanding Dilution

This brings us neatly on to what actually happens when you sell the stake.

Let's say that an investor offers you the £1 million for 43% of the equity. That means that the investor is valuing the entire company (prior to the investment) at £2.33 million, and in particular, valuing the 57% stake you will be left with at £1.33 million.

Suppose that prior to the investment the total number of issued shares (all owned by the founders) is 10,000. This means that the price placed on those shares is £133/share.

Why is it not the case that the price is calculated based on £1 million for 43% of 10,000 (giving £233/share), leaving the founders' 57% stake being worth £1.33 million?

Whilst the ownership percentages would be correct, this is not done because dilution takes place. In other words, the company issues new shares to the investor, rather than re-assigning existing shares.

In the above example, given a price of £133/share, the investor must be given £1 million/£133 = 7,518 shares. Post-investment, the company will be worth a total of £2.33 million, divided into 17,518 shares. The founders will hold their 10,000 shares (as before), but these are now only 57% of the company, whilst the investor will hold 43% (17,518 shares), worth a total of £2.33 million * 0.43 = £1 million.

There you have it: the end result is as proposed, i.e. the investor bought the agreed percentage for the agreed price. The only somewhat potentially confusing part is how this is brought about by dilution, rather than share re-distribution.

Lessons from Hermann Hauser

Another interesting Enterprise Tuesday lecture by serial entrepreneur and angel investor Hermann Hauser (Amadeus Capital Partners). He talks about the mistakes he has learnt from in five of the 62 companies that he has been involved with: Acorn, ATML, Harlequin, ART, and Polight. Here are my notes and thoughts:

• Acorn spent its first five years not being able to produce enough computers to meet the demand. It therefore signed long-term agreements with manufacturers, and eventually met demand. Unfortunately, at this point the market crashed. Inventory piled up, and the company had to be rescued by Olivetti. Corollary: understand the variations in your market, and plan inventory sizes appropriately.


• ATML's initial product was (probably) the best 25 Mbit/s ATM switch on the market. This did not sell, as 100 Mbit/s switched ethernet soon arrived on the scene. Larry Ellison (of Oracle fame), invested in the company, and hence kept it afloat. However, the company began to make significant sales of its ATM to IP "conversion" chip to manufacturers of DSL modems. The business model was then changed, resulting in real growth. A merger with American company Globespan was proposed, but this turned out to be a bad move, as their management team was not as strong as ATML's (by this time Virata). Corollaries: product strategy needs to be correct (and malleable); don't assume that as a British company you need to be bought by an American company to succeed.


• Harlequin's aim was to build the world's greatest AI company, by producing a LISP interpreter. But this wouldn't be profitable, as it would be a small market. In order to obtain revenue, the company produced PostScript technology for printers. The founder refused to raise cash through selling equity, but wanted to raise debt. Natwest gave him a £5 million loan. That increased to £10 million. The difference between banks and VCs is that banks can call in the loan. Harlequin was sold for £1. Corollary: in a fast growing, high-tech company, you need equity, not loan, finance.


• ART (Advanced Rendering Technology) made a break-through in hardware rendering technology. Genereated photorealistic images for car companies. But there were only so many car adverts that needed making! Corollary: market size matters!


• Polight produced holographic storage technology. Unfortunately, a very gifted physicist on the team showed that it was in fact impossible to produce the technology that they were working towards. Corollary: sometimes the technology itself may be at fault.


• Time estimation: whatever you estimate, multiply by Pi to get a realistic estimate. Similarly, market size estimates tend to be very overstated.


• People-related issues are common: people fall out with each other surprisingly easily.


• Finally, keep making mistakes, but make new mistakes.

Personally, I think that much of the above is obvious in hindsight. In other words, I'm sure that ART were aware that they needed a big enough market in order to generate sales growth long-term, or that Acorn would not have signed manufacturing contracts if it had known that demand was going to fall. Perhaps the most interesting conclusions to be drawn centre around how ATML was nimble enough to change their strategy (i.e. that they were willing to sell that one chip that was a tiny part of their much more complex core product), and that they would probably have done better not to merge with Globespan.

So how to avoid the "obvious" mistakes when starting out? Clearly it's not easy. Here's my take, for what it's worth:

• Market trends & inventory: of course, the ideal company is one that has no inventory, and yet can keep up with demand. If you're selling pure IPR, like chip designs (e.g. ARM), that's great, because inventory becomes someone else's problem. In the case of a software company (assuming its products are sold for download, or online use, rather than on shop shelves), inventory perhaps becomes synonymous with how much server capacity you have, plus possibly support staff. Hence, using cloud computing services such as Amazon's EC2, (or their content distribution network, CloudFront) and outsourcing non-core work to contractors (as suggested by Seedcamp's Reshma Sohoni) provides much greater flexibility to respond to demand. Of course, reading market trends hopefully means that you're aware of what proportion of your services are "base load" and hence could be performed in-house.
• Product strategy: be prepared to admit that your first idea didn't work, but that a part you never envisaged could be valuable actually might be. Concentrate on your core competencies.
• Market characterisation: talk to your potential customers! I find it incredible that there are so many web sites that make it so hard to give good feedback once they're selling (and that's after they've decided on their product!). As David Langendries pointed out in a comment on my post "The Dangers of Online Feedback", companies would do well to pick up the phone. Most successful products are preceded by good marketing (distinct from advertising), says Seth Godin. Which to me, means that technologists need to be very sure they can convince the customer that their product solves a problem that the customer (maybe) never realised they had. And convincing means talking, rather than yet another online survey.

So there you have it: terribly simple, right? ;-). Then again, you'll find plenty of other conflicting advice elsewhere. Over at OnStartups, Jason Cohen suggests that instead of trying to figure out which strategy is best, given that conflicting ones have produced equally successful companies, perhaps you just need to buck conventional wisdom (and hence not copy 37signals or Fog Creek)... Thoughts?

The Dangers of Online Feedback

Business Week has a very interesting book excerpt from "What Would Google Do?" (Jeff Jarvis), titled "Detroit Should Get Cracking on its Googlemobile", which caught my eye, in part, because I'm currently reading Tom Vanderbilt's "Traffic: Why We Drive the Way We Do (and What it Says About Us)". Jarvis points out that at present auto manufacturers don't really communicate with their customers about what they would like, or allow them to customise their cars in any meaningful fashion. If they had, he argues, we would have had ways to interface our iPods with our car radios long ago. In the future, if they treated cars as a platform that allowed users to create their own cars, we might see unpainted cars being sold, then taken to local graffiti artists. All hail "open-source" (?!) cars, apparently, not to mention open-source urban planning.

That got me thinking. Many large corporations are today accused of not listening to their customers. Meanwhile many are trying to use the Internet to change that (take a look at Get Satisfaction). It used to be that to listen to your customers involved conducting telephone or paper surveys, or paying people to be in focus groups. Now you can just set-up an online forum, or blog about your ideas and see what comments come back. In many ways that's good: the cost of soliciting feedback is minimal, so even one-person startups can do it. The bad bit is that the company has to take the time to actually listen.

Whilst older companies have a reputation for not asking for feedback, it seems to me that the newer technology companies have a bad history of actually listening to feedback that concerns policy. That's distinct from feedback on software bugs, which are effectively win-win for the company and the consumer. Google, for example, is great at releasing its products in beta versions, and fixing them up in response to feedback. However, looking at the upset surrounding its retention of search logs, and it's the opposite. Similarly, Facebook's introduction of its Beacon technology, for publicising what purchases users had made, didn't really go down that well either, though they at least made the service an opt-in feature after about three weeks. (Any other examples?) The point is not that users aren't eventually listened to, but more that they're listened to quickly or completely only when the company considers it to be commercially sensible.

"So what?", you might ask, "Isn't that obvious?" Well, to a company, yes. Pandering to users whilst potentially cutting your revenue or effectiveness doesn't seem commercially sensible. But if consumers now expect this easy-feedback channel to be taken notice of, then when it's not, a revolt occurs. On the web, where the switching costs tend to be lower, customers might just decide to go elsewhere. Even with companies who produce more tangible products (cars, say), users can still make a fuss very publicly, and very quickly. Worse, they'll accuse the company of "not listening". Suddenly the feedback channel isn't so great any more. Particularly since a lot of that feedback is public for all the world to see.

So, as a small company, online feedback can be great for understanding how to shape something new. But it's perhaps important to manage users' expectations. Otherwise you might end up like Face Party, who closed shop for a while after users complained that they hadn't been given what they'd been promised. Moreover, dedicating time to making sure that the online feedback channel is tended to, so that you at least appear (!) as though you're listening will probably pay off.

Welcome to a brave new world, where goodwill is generated by listening, rather than another PR campaign. Oh, and where trying to fake reviews to gain goodwill will probably be discovered.

The E-Myth Applied to Software Startups

In his book "The E-Myth", Michael Gerber asks why most small business don't work, and what to do about it. His main point is that people who go into business on their own tend to do so in order that they won't be working for someone else. Moreover, they tend to be the "worker" or "technician" type (not the manager, or strategist), who is good at creating the widgets/loaves of bread/furniture/other product. So they open a widget workshop/bakery/carpenter's workshop/other place as a one person venture.

So far so good. The new business probably works well, because the owner has enthusiasm and is skilled in what they do. However, the owner spends all of their waking hours attending to the work of producing the product. Gerber gives the example of a pie shop, where pies are baked early in the morning, sold throughout the day, and cleaning is done in the evening, all by the owner. The owner probably neglects areas of the business they don't know much about, such as book keeping. Neither do they get any time off. Crucially, they don't sit down and think where the business is heading (strategy).

Gerber argues that most of these people need to let their inner entrepreneur blossom. They need to own the business, rather than the technical work that goes into product manufacture. They do this by having a vision of the future of the company, and shaping the company to it, rather than shaping the future by what routine dictates. As they grow the company, they need to impart this vision to their new employees, and begin to make that vision a reality by taking on more of a managerial, and less of a technical, role. Part of this, Gerber, argues, involves documenting all the processes (e.g., how to make pies) that go on in the business, in order that the owner no longer has to check up on every step of production done by his/her employees. The result is a business that is easy to franchise.

Whilst this all makes sense for a business that produces something tangible, how can we apply it to software startups? Whilst not having a huge experience in this area, I thought I'd have a go at answering this question.

Firstly here are some of the differences I can see between the two situations:

• The capital cost of writing software is relatively small, unlike the initial investment required to rent a retail unit for a shop, or build a factory. This means that non-software businesses have to go and find funding, which normally means other people will take a look at their business plan before the business is set up. If you're spending life savings then it's different, but if you're writing software you're doing that too (just to keep food on the table)
• One doesn't tend to want to franchise software production. Outsource, possibly, and certainly bring new developers onboard. But the procedures that the startup uses won't be set in stone by the owner: they'll change as the company grows. What revision control system you use, or bug tracking software, or code format only needs to be specified at a later stage than what recipe is used for pies in a bakery.
• The cost of modifying software is very small. The cost of changing every widget that you have in stock because there's a flaw in it is at least linear in the number of widgets, so you'd better get it right first time. With software you can "plan to throw one away" (Fred Brooks; see my post The Mythical Man Month: Still Applicable Today).
• If a software product is intended for mass market, it's likely that its users will not understand how it works, and can't easily reverse engineer it to find out how. This is very different from most tangible products: most people understand vaguely how a pie is made, or have a mental model of how a car accelerates from standstill.
  

(I'm sure there are more: comment and let me know!)

I do think that technical people are as susceptible as any others when it comes to "working in their business rather than on it" (Gerber). But what exacerbates the issue is that software startups don't need initial cash, and hence owners aren't obliged to have anyone looking over their shoulders! Add to that the ease of (radically) changing their product, and suddenly the software startup is one where it's far more acceptable to have no real vision or idea of what you're doing. It's therefore very easy to waste time and then fold.

Software engineers are highly technical. In my experience, many dislike having to explain to a customer how a product works, and would hate to provide a dreaded technical support helpline. Instead, they argue that software can be made good enough that no support is needed, or those that do need support are evidently so lacking in intelligence that they don't deserve it. Yet this is crucial to getting the product sold to a mass market! Customer service is perhaps most needed in this business, and yet the software engineering stereotype is the worst-placed to provide it!

Linked to the previous point is the observation that performing market research is difficult. For a pie shop it's pretty easy: "Do you like apple pie, or would you prefer blackberry?" Software isn't as easily understood by the man on the street: "Would you like to buy my new super-fast sorting algorithm?" doesn't mean much. It requires the software engineer to divorce themselves from the beauty of the technology, and concentrate on its use by potential customers.

Another interesting issue with the low cost of modifying software is the speed at which new technologies (languages, tools, plug-in modules) become available. Unless a lone entrepreneur has a strong vision and will, it is very easy to frequently change to the newest technology, in the belief that this will create a better product. Of course, sometimes it does. But change has a time cost, which is much harder to quantify than the capital cost of buying a new piece of hardware, say.

Finally, as noted above, documentation of processes is far less important (in my opinion) for a software startup than for widget production. Gerber argues that documentation means practically anyone can read the "manual" and then achieve good results. I would argue that software is different in that it requires excellent people, as code quality can only be influenced by procedures to a small extent. In addition to good software engineers, there is a real need for one person with an overall view of what the aim and uses of the product are: they can then ensure that all the developers work in concert towards the vision of the company.

If You Get a Little Better at Sales, You'll Be Way Ahead of the Market

In my dealings with fellow Computer Scientists, I've noticed that many don't see the point of sales and marketing. Instead, they focus on technology. That is not to say that they are all totally unaware of sales/marketing, but if they do see the point, they see it as someone else's task, definitely not one for them to get involved in. In another excellent presentation from the Business of Software 2008 conference, Paul Kenny (of Ocean Learning) talks about how to be a better salesperson. Crucially, he dispels many of the myths that technical people hold about the role, addressing those in startups in particular. Here's the video, with my notes below it.

• If you have a bad opinion of salespeople, it's likely to be because you have experienced the "bad apples", rather than sales being a terrible thing in principle.
  
• Myths
  
• Products "sell themselves". (False, though great products can sell themselves to an extent.)
• Our customers "don't like being sold to". (Actually, they don't like being sold to badly!)
• Techies don't "get" sales people. (Not true! You sell to VCs, to your friends/family supporters, to your first employees.)
  
• How many of the people who, say, view your marketing video, call you for a demonstration? If it's only 5% (likely!) then you need a person to follow up: normally it's not something wrong with the product that stops someone buying it; it's other things getting in the way.
• The people who have the need for your product are probably not the people with the money. You need a salesperson to go and talk to the people higher up, to make them feel the need.
• Talk about specific uses/users, not the science/how the product works. If you can convince your buyer that a user they know personally will benefit from it, that is a powerful sell.
• Users have "needs behind needs". People will tell you that the reason they buy an SUV is because they like the 4WD or stability. In practice they actually like SUVs because they make their families safer when driving, or for the feeling they get when they are able to look down on other drivers.
• Be prepared to go one-to-one with customers to understand their particular situations and what features they will use.
• Sales are very dependent on the emotional impact of your product. You need to position your product in people's minds. Trade-off between perceived cost and perceived value. Note that it's perception that matters, which can be managed by a salesperson.
• If you want a salesperson, don't recruit a stereotype! Start with what you need them to do: fast response (cheap product), or in-depth service (expensive product, high risk for client). They require different skills.
• What is your company culture? Will the salesperson you are recruiting exude that culture? Don't stitch customers up.
  
• Don't worry about admitting that your product isn't suitable for a customer's needs; they will remember you, as you'll probably be the first person who was honest with them in that way.
• Don't hire experience, hire attitude first (then experience!). You can't train attitude into someone. If a candidate hasn't researched your company much at all, or is lax in some things, don't hire them: they will be the same about your customers.
• Skills: self-starting/self-motivated, intelligent in questioning/listening, sounds/looks like they mean it, can deal with resistance, persistent.
• Sales take huge amounts of energy: have a dedicated person, rather than combining with other jobs. If you can, have more than one salesperson to spread the load, and motivate each other.
• If you have no dedicated person, and all of you in the company do some sales, come together and do it at the same time.
  
• Don't just reward deals: that will result in salespeople who don't care about the customer. Instead, reward contact with customers, and show interest in those skills.
• Sales can be boring: how can you vary your salesperson's job, on a regular basis?
• Train your salespeople regularly. They will go off the boil otherwise.
• For high-value salespeople, bonus them over 6-12 months, as such sales take a long time. Low value sales are different, probably bonus over short term.
  

Ultimately, show your salespeople that they are hugely important to you, motivate them, and ensure that they develop relationships with customers.

Tips on Pitching to Investors

I went to a seminar some ago (part of the Enterprise Tuesday series) by Alex van Someren (nCipher) and Adrian Critchlow (AlertMe) on how to pitch to venture capital firms. You can get the slides describing how to pitch, but I've also made some very brief notes.

Make 10 slides, consisting of:

• Company logo
• Business overview
• Management Team
• Market
• Product
• Business model
• Strategic relationships (with other companies)
• Competition
• Barriers to entry (for you and for others)
• Financial overview (3 to 4 years, if you're talking to a VC. What are the drivers, how can profit be increased?)
• How will you use of the money you're asking for (first three purchases or hires)
• Company's capital and current valuation

(Obviously not all of these can be one slide!)

Note that if you show a demonstration of your product, it's best to record it, rather than do it live! Videos work well for this.

This also seems a sensible way of thinking about a new product idea, rather than just being useful for investor pitches.

Dharmesh Shah on Everything He Knows About Startups

Just watched Dharmesh Shah's talk at the Business of Software 2008. He writes over at On Startups.



Interesting points:

• Building a reasonable ($30-40 million) business is perfectly respectable
• VC money is not a requirement
• If you're not embarrassed by your initial release, you've waited too long to release
  
• No one reads business plans. Write a blog instead, to get the idea out there and commented on as early as possible (don't worry about competitors finding out your idea; it's hard enough to get someone to fund you, never mind convince a competitor that your idea is better than theirs)
• Toy companies try out the advertising, then build the product. So sell pre-alpha versions of your product and figure out what people want
  
• Don't bother doing partnerships: they don't work
• Don't buy ad words: concentrate on getting a good page rank. That way "advertising" is free, and you can't be immediately displaced by someone paying a higher price
• Software as a service is great: but the margins are small. You now have to do all "tech. support". But you get detailed information as to which features your customers use, and what retains them
• Figure out what the impact of each feature will be on your customer retention/happiness
  
• VC syndication (where multiple VCs get together and fund you) is like price collusion. You need other players who will help to set the right price (a market of one means they set the price arbitrarily)
• Pricing your product is very hard. Pick a number, and then change on the basis of experience.