David Rubenstein is the founder of Carlyle Group, a publicly traded private equity firm in DC. The firm has about $373 billion in assets under management as of this writing. David is a good example of what I call investor entrepreneurs—investors who have an entrepreneurial spirit and found their own investment firms rather than work for someone else. I’ve been learning more about David’s outsize success and the founding of Carlyle. I listened to an interview he gave recently at Wharton’s Private Equity & Venture Capital (PE/VC) Club.

David believes that culture is one of the most important things in an organization. He was purposeful in crafting the culture of his firm, and it’s been a competitive advantage and part of Carlyle’s brand. David was asked what’s needed to build a great culture. He shared something I didn't anticipate: persuasion skills. He went on to say that life is about persuading others to do what you want. Family, coworkers, friends, spouses, everyone—if you can persuade people you’re right and get them to do what you want, it’s an advantage in life and helps build a great culture.

He explained how to persuade people:

• Writing – Effective writing is important because it helps you communicate your point succinctly, which can persuade others.
• Talking – Oral persuasion is about making your case by speaking. If you can speak clearly and succinctly, that will help you be persuasive. Practicing helps.
• Actions – Leading by example is an effective way to persuade. Do what you want others to do to set an example that they’ll follow.

David is right. Persuasion is an important life skill that can be a superpower for entrepreneurs who lead other people. Culture is about how people act while they execute the company’s mission. Effective leaders are good at persuading their teams to act in a manner that aligns with the company’s core values.

A founder asked me for some feedback because he’s not sure what to do. He has a team member who isn’t pulling his weight. If he keeps the team member, a critical part of the company will continue underperforming. The team is small, fewer than ten people, and everyone, including the founder, is stretched thin. If he parts ways with the team member, he will have to do this person’s work until he finds a replacement.

After more conversation, this founder acknowledged that he’s wanted to let this team member go for some time but has avoided it. He isn’t sure how he’d manage his current workload, do this team member’s work, and recruit a replacement simultaneously.

This is a common early-stage founder dilemma. The founder knows what he needs to do but isn’t sure how to do it. Said differently, the decision is easy, but the implementation is hard. I was in this exact same position as a founder. I learned that it’s better to rip the Band-Aid off and deal with the pain than to let the problem linger and turn into a bigger one. Taking on the departed team member’s work wasn’t ideal, but it better prepared me to train the next person and motivated me to get the right person in place so I could reduce my workload.

When faced with an easy decision but onerous implementation, I learned that delaying the decision isn’t feasible and can make bad situations worse. I needed to make the tough decision and view its implementation as a learning experience. Just as I’d figured out other seemingly impossible parts of entrepreneurship, I could figure how to navigate the side effects of decision-making too. Ironically, when it was done and I was on the other side of it, I realized that anticipating going through with decision had been way worse than doing it. I always wished I hadn’t waited so long (especially with personnel changes)!

I had a chat with a friend and fellow venture investor recently. He’s raising a fund and pitching lots of limited partners (LPs) to invest in it, which got me thinking about what LPs want.

In general, there are various types of limited partners: high-net-worth individuals, family offices, corporations, pensions, endowments, and more. LPs are motivated by different things. To understand whether your fund strategy is aligned with a particular LP, it’s important to understand their motivations.

In my conversations with LPs, I’ve noticed that returns matter to all LPs—but not always cash returns. Most people think that when a fund makes a distribution to its limited partners, it’s in cash. This is often the case. But general partners (GPs), who manage venture capital funds, can choose to distribute stock in a company to their limited partners. This is called an in-kind distribution. For example, if a company has an IPO and goes public, the GP can give the public shares to the fund’s LPs. The LPs can then choose to hold the stock or sell it based on their objectives.

Some LPs want their returns paid in equity. They want in-kind distributions. If a GP invested in a great early-stage company that will produce large profits and distribute dividends to equity owners, or that will continue to grow rapidly and increase in value, these LPs want to go along for the ride. They’re less interested in companies that have no clear path to profitability because they want to own assets for decades.

I’m not sure if this type of LP is in the majority or the minority. I suspect that most GPs target cash distributions (for a variety of reasons). If GPs target investing in companies that LPs can own for decades, I imagine that changes what companies GPs invest in and how they want the companies’ founders to grow their companies.

Imagine if the venture investors who seeded Apple or Microsoft distributed securities to their LPs and the LPs still held those shares today. Between appreciation and dividends, the returns would be amazing. So would the rate of compounding from the initial investment by the GP until today.

I wonder how many venture funds target in-kind distributions so their LPs can own the companies they’re investing in for decades?

Today I was chatting with a “spotter” entrepreneur about the details of an opportunity he’s considering pursuing. He plans to build a business to solve an overlooked problem of solopreneurs. He needs capital to launch the business but doesn’t have experience raising capital from investors, so he asked for my thoughts on structuring a deal that includes investor capital and bank debt.

As we chatted about the business model and numbers, we began discussing the bank debt portion of a possible deal. In the past, he’s used his own capital and bank debt to launch businesses. But interest rate increases mean that debt service on a loan would materially reduce cash flows from the business. This spotter has his own capital, but not enough to finance this entire project. Nor does he want to take on that much risk. Given this reality, he’s considering, for the first time ever, raising capital from investors. The problem is, he doesn’t know where to start.

When interest rates were low, spotters could partner with banks exclusively. The principal and interest on their loan payments didn’t materially impact cash flow, and they maintained 100% ownership. They preferred to work with a banking partner and cheap debt rather than give up equity to investors and have to report back to those investors.

In today’s interest-rate environment, selling an equity stake to investors can be a more attractive alternative. Deals where bank debt would significantly reduce returns or cash flows because of high rates can be more palatable with investor capital. Of course, this depends on how the deal is structured. The devil’s in the details.

Today’s conversation got me thinking. How many more spotters are doing the same math and coming to the same conclusion: I should consider raising capital from investors. If it is—or will be—a material number of people, this could be an interesting market that will likely be underserved.

I want to follow up on yesterday’s post about recurring and transactional revenue with an example. Coinbase is a publicly traded company whose financials are publicly available. It offers a variety of products, but most of its revenue is made on fees charged when customers buy or sell cryptocurrency assets on its platform. This fee-based revenue is transactional since Coinbase doesn’t know when customers will transact or how much revenue it will receive when they do.

Coinbase’s latest 10K filing for the fiscal year ending December 31, 2022, shows us how the transactional nature of its revenue affected its financial performance:

• 2020: $1.27 billion in revenue and $868 million in operating expenses for $409 million pretax income (profit). Pretax income was ~32% of revenue. Operating expenses were ~68% of revenue.‍
• 2021: $7.83 billion in revenue and $4.76 billion in operating expenses for $3.02 billion pretax income (profit). Pretax income was ~39% of revenue. Operating expenses were ~61% of revenue.‍
• 2022: $3.19 billion in revenue and $5.90 billion in operating expenses for a $3.06 billion pretax loss. Pretax loss was ~96% of revenue. Operating expenses far exceeded revenue (~185% of revenue).

Coinbase’s transactional revenue fluctuated wildly during those three years. As revenue soared from 2020 to 2021, Coinbase’s expense structure also increased. This makes sense because you need more people and resources to service an increase in customer demand. As revenue plummeted from 2021 to 2022, the company’s expense structure continued to increase, causing a massive pretax loss.

Revenue increased over 600% one year and dropped almost 60% another year. While this is an extreme example because of macro factors, Coinbase demonstrates how hard it can be to forecast and plan when there are no agreements between a company and its customers that produce recurring revenue.

I’ve chatted with a few founders who proudly share their recurring revenue numbers to show how their businesses are growing. But their revenue isn’t recurring. They aren’t trying to mislead—they often don’t know what “recurring revenue” means.

Revenue is recurring when the customer has agreed to pay a predetermined amount over a predetermined time. Subscription revenue is a great example. A customer signs an annual contract for $1,200 and agrees to pay $100 per month on the 1st of every month. Alternatively, the customer could give you the entire $1,200 up front to gain access to your solution for the year. Either way, the duration is a calendar year and the amount paid is $1,200.

Another wrinkle on subscriptions is monthly software with no contract. Let’s say a customer signs up for a SaaS tool such as Calendly, agrees to pay $10 per month, and can cancel anytime. This is still subscription revenue. It’s a one-month subscription that auto renews at the end of every month unless the customer cancels. The duration is a month, and the agreed-upon amount is $10.

The great thing about recurring-revenue businesses is that they start with a known amount of monthly revenue that customers have agreed to. Customers must notify the company when they plan to stop paying, which gives the company prior knowledge of when revenue from a customer will decline. This revenue base makes planning and forecasting more accurate for small and large companies.

If revenue isn’t recurring, it’s likely transactional. Transactional revenue doesn’t involve predetermined amounts, and the frequency of payments varies. Grocery stores are great examples of transactional-revenue businesses. Customers can walk in whenever they want and buy as much or as little as they want. There’s no commitment between the store and the customer. Every month, the store starts with a revenue base of zero. Customers don’t have an obligation to notify the store if they’ll stop shopping there. This can make planning and forecasting difficult until the company has a large customer base.

If you’re building a transactional-revenue business and want to demonstrate that revenue is growing, don’t use terms like “recurring revenue” or “annual recurring revenue.” Consider something like “revenue run rate” or “annual revenue run rate” if it makes sense for your business.

In yesterday’s post, I shared the difference between wealth and income. Here are some ways for founders to think about wealth, income, and company building.

A business that makes creating income for the owners top priority is usually optimized to do so. That means that cash generated by the business is removed from the business for the benefit of the owners. And it usually means that the company isn’t reinvesting in growth opportunities as heavily as it could. The focus is on how much cash the company can generate and distribute to owners.

A business focused on creating wealth is focused on growing the value of the business. To make that happen, the business is trying to scale its solution quickly. Cash generated by the business is reinvested in growth opportunities within the business. The company may even raise outside capital (i.e., venture capital) to accelerate growth. The founders of these companies usually target getting a windfall when they sell all or part of the company after it reaches material scale.

Most companies I see fall in one of these two buckets. But there are exceptions. Some founders build companies that are hybrids: extremely profitable and high-growth companies that generate income for owners and increase the owner’s wealth rapidly because the business value skyrockets. The hybrid businesses I’ve seen have high profit margins, which drives their profitability, and solve a painful problem well, which drives their growth. This type of business is very attractive and tends to be valued richly. The founders of these companies (if they have majority ownership) control their destiny because they’ve created an asset that both materially increases their wealth and provides income.  

You’re unlikely to build a big company in a small market. The solution may be great, but if there aren’t enough people with the problem, the company’s upside potential is limited. Today I read a blog post from Bling Capital that provides a simple framework for quickly sizing a market. Here are a few takeaways:

• Bottoms up – Don’t take a top-down approach that focuses on getting a percentage of a known market. That can severely underestimate a market. An NYU professor made this mistake when he claimed that Uber was overvalued. A bottoms-up approach that also considers new use cases enabled by a superior solution is better.
• Customer segmentation – All customers aren’t equal. Different customers will require different go-to-market strategies.
• Penetration rates – Be realistic about how much of the market you’ll capture. Fifty percent isn’t realistic for most companies, but 5% is. Penetration may vary by customer type (e.g. urban vs. rural).
• Gross profit – The cost of delivering a solution matters a lot. It’s an indication of whether the company can become profitable. Growing revenue or GMV quickly but with low gross profitability makes the path to turning a profit much harder.

Every market is different and founders should consider the nuances of their market when sizing it, but this framework is a good starting point.

Today I had a chat with a friend who made a comment that stuck with me.

I’m not a start-from-scratch kind of person. It’s not my strong suit. I need there to be something in place already that I can improve and scale.

My friend, over an accomplished career, has learned this about himself. He isn’t a blank-canvas person. He has no desire to start a company. He needs there to be pre-drawn lines to a bigger picture or vision. He can then work within the outline of that picture to turn it into something amazing. He considers only opportunities that align with this criterion. His skill set makes him well suited to be the right-hand man of a big-picture entrepreneur who knows exactly how he or she wants to solve a particular problem.

As a former founder, I’m comfortable starting from scratch. A blank canvas is attractive to me. I enjoy the process of coming to understand a problem and creating a solution from nothing. Once I know what needs to be built, I can draw the lines on the canvas and start building a masterpiece.

For anyone who wants to be a founder, a comfort level with a blank canvas is necessary.

I read a quote that’s stuck with me:

I hear and I forget. I see and I remember. I do and I understand.

                                                                                  ~ Unknown

Seeing something being done is helpful, especially if you have a blank canvas and don’t know where to start. You’ll remember what you saw, but that doesn’t guarantee you’ll understand why it was successful or unsuccessful. When you try to replicate what you saw, that’s when it starts to click and make sense. The true learning and understanding happen by doing. We learn what we do (or attempt to do).