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In a lot of ways, it didn鈥檛 seem like a very good experiment to run.
A young HBS professor鈥攁 rising star in the Finance area, an economist by training, by then already looking down the road at an all-important tenure decision鈥攈ad an idea for a novel second-year MBA course, in which he would combine then-emerging thinking at HBS about entrepreneurship with some new kinds of financial strategies he had been roughing out.
Entrepreneurial Finance seemed like a logical name for the course.
Almost nobody up the food chain from聽聽offered much encouragement.聽Entrepreneurship is like an intellectual onion, one of his Finance advisors told him.聽You peel it and peel it, it makes you cry, and there鈥檚 nothing in the middle.聽There were some exceptions to this institutional indifference, including Sahlman鈥檚 mentor on the faculty,聽鈥攈imself the spark plug behind the School鈥檚 recent push into entrepreneurship. And behind Stevenson was Dean聽, quietly determined to steer the School into the tempting but elusive field of new ventures, and willing to back people who were brave enough to serve as the point of that spear.
A second senior advisor delivered some further bad news.聽The higher the teaching ratings you get, he told Sahlman,聽the more likely you won鈥檛 be promoted.
Come again?
Entrepreneurship is amorphous. It鈥檚 storytelling. And storytelling is extremely popular with students, but so too would be a course on how to manufacture LSD. You can鈥檛 get traction. Just don鈥檛 go there.
Sahlman was daunted, but he wasn鈥檛 dissuaded. He had some momentum. He had been writing cases and notes on entrepreneurial ventures since his arrival at the School in 1980. But all along, that had been a solo effort, and as a result, he had nowhere near enough material for a full-credit course. So he decided to offer a half-credit course instead鈥�15 sessions rather than 30.
There was always the risk of embarrassment:聽Maybe no one would sign up.
On the other hand…
Sahlman knew for a fact that whenever one of his colleagues offered a course that focused on聽people in a deal-making context, students signed up in droves. That had been true for the real estate courses that Howard Stevenson and practitioner-academic聽聽had taught in recent years; it had been true for the Starting New Ventures course that former faculty member聽Pat Liles聽had run years earlier; it had even been true for some of the less-than-compelling entrepreneurship courses that had been offered in the recent past. Even when the supply faltered, the demand never went away.
And in the year that was just ending, Sahlman had taught first-year Finance to some 180 students鈥攖wo sections of 90鈥攚ho had rated him highly as a teacher. This wasn鈥檛 always the case. 鈥淟et鈥檚 get that on the table,鈥� he recalls with a typical wry grin. 鈥淢y first two years at HBS, I was the lowest-ranked Finance professor.鈥� But since then, he had gotten better in the classroom鈥攚ay better. His student ratings had improved dramatically. Surely聽some聽of those 180 satisfied customers, now choosing their second-year electives, would humor Professor Sahlman and sign up for his adventurous new course.
Wouldn鈥檛 they?
Sahlman believed he had a conceptual structure for the course that might protect him from the dreaded Onion Outcome. 鈥淢y goal from the beginning,鈥� he recalls, 鈥渨as not to dump all of the economics and become a storyteller鈥擨 had been warned about that!鈥攂ut rather to create an economic analytical framework that made sense.鈥� As a starting point, he drew on Poorvu鈥檚 and Stevenson鈥檚 prior work, which focused on four elements:聽people, opportunity, context,听补苍诲听deal. To that framework, Sahlman added a notion of聽dynamism鈥攃hange over time鈥攖hat underscored the changeable nature of all the component parts. 鈥淚n other words,鈥� he explains, 鈥渨ho can add what elements to the mix to increase the chances of the venture succeeding over time? And conversely, what can be done to stop things from going wrong and getting yourself kicked out of the game?鈥�
Sahlman cites the famous example of Jobs and Wozniak at the birth of Apple Computer. 鈥淲ere they the right guys to create a hand-assembled computer motherboard company in 1976?鈥� he asks rhetorically. Answer: sure.聽But鈥攚ere they the right guys to build a major personal computer company? No. That only became possible when, at the insistence of the venture capital community, former Intel executive Mike Markkula joined the team.
鈥淪o in that way,鈥� Sahlman continues, 鈥渋t鈥檚 different from real estate. It鈥檚 about,聽how do I create experiments that reveal to me, and to people outside the management team, that this makes sense and is going to succeed? It鈥檚 a multi-period, high-uncertainty-that-needs-to-be-resolved kind of process.鈥�
Sahlman鈥檚 revised framework soon proved a useful tool for understanding the seemingly chaotic world of entrepreneurial finance: 鈥淚t captured what I was seeing in the world of practice,鈥� he says. 鈥淎nd it stood up to the take-something-away, add-something test. Which of those building blocks could you live without? None. What would you add to make it more complete? I still haven鈥檛 come across that missing piece.鈥�
So with a field-tested framework in hand, Sahlman launched his course in the spring of 1985.
In theory, there were 200 available seats. That was nowhere near enough for the 450 students who signed up. And who signed up in droves the following year鈥攔equiring the teaching of two additional sections by Sahlman鈥檚 senior colleague聽Warren Law鈥攁nd the year after that, and the year after that. By 2017, some 10,000 students had taken the course. Beginning in 1999, moreover, every first-year HBS student has taken a required first-year course called The Entrepreneurial Manager, which draws heavily on the content of Entrepreneurial Finance. And this past year, Sahlman鈥攏ow retired, and several years away from the Entrepreneurial Finance classrooms鈥攍aunched an online version of the course through HBX, attracting students from around the globe.
The experiment, as it turned out, was well worth running.
He was, by his own admission, 鈥渁n overeducated economist鈥� who greatly enjoyed the economist鈥檚 normal pastimes of rummaging through data sets, crunching numbers, and testing theories.
But one day, he found himself hung up on the opening line of a teaching case:聽DuPont was considering entering the titanium dioxide market.聽Sure, there was some contextual material, as well as reams of financial projections focused on a proposal to build a titanium dioxide plant. But there were no聽people聽in the story. 鈥淣ot even any DuPonts,鈥� Sahlman laughs. 鈥淟ong dead. Long gone.鈥�
Here, Sahlman interrupts his own train of thought. 鈥淗ey,鈥� he says, 鈥渋t鈥檚 a fine case, cowritten by a close friend of mine,聽. He takes some offense when I beat up on it. Sorry, Carl!鈥�
Sahlman鈥檚 perspective was influenced by his father, a successful manager who had dealt with similar kinds of resource allocation issues. Sahlman knew that in such circumstances, his dad had聽always聽concentrated on finding the right people. 鈥淢eanwhile, at HBS we were teaching what I called 鈥榥eutron bomb鈥� cases,鈥� he recalls. 鈥淟ots of numbers, no people.鈥�
There was more. Many finance cases at the time focused on pricing securities and pricing risk. 鈥淚n finance,鈥� Sahlman says, 鈥渨e hold the view that you only get compensated for bearing non-diversifiable risk鈥攊n other words, what鈥檚 left over after you take all of these disparate projects and throw them in a single portfolio of every risky project in the world. And yet, everywhere I went, venture capitalists were using high discount rates, and it wasn鈥檛 clear how that related to risk. Here鈥檚 a bunch of people giving money at 50 percent to projects that really should only be charged 10 percent. Well, if markets work correctly, after a little while people will come rushing in, bidding up the price of the project so that they鈥檒l only earn the 10 percent. That鈥檚 how markets work, right?
鈥淏ut the fact was, no one was rushing in, because those venture capitalists weren鈥檛 actually using 50 percent discount rates,鈥� he continues. 鈥淭hey were simply trying to reflect the resolution of uncertainty. They were saying, 鈥榃ell, if a lot of things went right鈥攖hat is, a single scenario among many that were likely鈥攖hen I could discount the success scenario back to the present, and make a rational decision.鈥� So it鈥檚 really quite a different thought process, and it suggests answers to a whole bunch of questions beyond just the high discount rates: Why do they always use convertible preferred stock? Why do they stage the commitment of capital? Why do they intervene and try to be helpful鈥攐r in some cases, screw things up?
鈥淪o our thinking got sharper. Yes, from whom you raise money can be as important as the terms鈥攂ut the terms matter too, because you鈥檙e in a multistage process where winning at each stage doesn鈥檛 matter. It鈥檚 winning at the end, not at each point.鈥�
People, opportunity, context, and deal, changing iteratively over time. Sahlman cites a contemporary example: the Casper 鈥渂ed-in-a-box鈥� foam mattress company that launched in 2014. 鈥淪uppose I come up with an idea for a foam mattress I can stuff in a box and ship directly to customers. Well, there鈥檚 a lot of uncertainty in that project, right? I don鈥檛 know if I can make the mattress. I don鈥檛 know if people will buy it online without trying it out first. I don鈥檛 know if I can stuff it in the box. I don鈥檛 know if the postal service will deliver the box. I don鈥檛 know a聽lot聽of stuff, right?鈥�
And what about those pesky聽people, in Sahlman鈥檚 conceptual framework? Sahlman likes to point to the example of Mitch Kapor, whose r茅sum茅 in the early days鈥攊f indeed he had one鈥攚ould have reflected an extended college plan, two years as a disc jockey, a year teaching Transcendental Meditation, and several years earning a degree in counseling and working in a hospital outside Boston. Then Kapor cofounded Lotus Development, the company that developed Lotus 1-2-3, which crushed VisiCalc, which was the聽ur聽spreadsheet company that had helped make the Apple II a viable business tool.
What classical economic model could have predicted that?
鈥淚t was assumed,鈥� Sahlman says of the theory that he was increasingly inclined to challenge, 鈥渢hat the people involved were rational decision-makers, that the markets all worked, that everybody had access to the same information, and that there were no transaction costs. None of which, of course, applied in the world of ventures.鈥�
Uncertainty and the unknowable, moving in risk-filled directions, all at a fast clip. Says Sahlman: 鈥淎ll I was trying to do was to understand, How do entrepreneurs make decisions? How do the people who give them money make decisions? Does it matter who starts it? Does it matter who funds it? How does it evolve logically over time? What insights could you derive from studying that particular set of circumstances, where there鈥檚 lots of uncertainty and lots of agency problems, meaning that one group may not behave in the best interest of the other group? How do they structure contracts? More fundamentally, why would anyone ever invest in this area, and why would anyone in the world of entrepreneurship ever bear the enormous personal risk associated with the process? In fact, it was less about entrepreneurship and more about decision-making.鈥�
So Sahlman鈥攆irst alone and later with several junior colleagues鈥攗ndertook to understand decision-making both on the entrepreneurship side and on the financing side. He soon started seeing interesting patterns. The entrepreneur got a little cash somewhere鈥攎aybe from friends and family, maybe from an investor鈥攁nd ran a structured experiment aimed at learning something specific. If the experiment was successful, maybe another group of investors gave the entrepreneur a little bit more money to run another experiment. In other words, it was an iterative and disciplined process, which continued until the startup failed, changed dramatically, or succeeded.
This realization, in turn, led Sahlman to focus on聽execution鈥攖he proving ground for people, opportunity, context, and deal. For example, he wrote about the contrasting implementation strategies of Ovation Technologies and Lotus Development, allowing his students to get a handle on why getting financing through software-industry guru Ben Rosen (Lotus) led to a different and more effective execution than getting end-of-tax-year money from Chicago-based commodity brokers (Ovation). He also wrote notes providing deep industry and sector background for the software cases (and in the process, helped shore up his traditional academic credentials). And not least, Sahlman persuaded both Tom Gregory and Mitch Kapor鈥攖he heads of Ovation and Lotus, respectively鈥攖o come to class when their cases were being discussed. Students in Entrepreneurial Finance knew that, as they struggled to understand why the protagonists acted as they did, they might soon be getting the answer firsthand.
Consistently, Sahlman tried to focus on what he calls the 鈥渇omenting attack鈥濃�攖hat is, the agent of change that was attempting to change the rules of the game and disrupt an entrenched player: Amazon vs. Barnes & Noble, Uber vs. the taxi industry, and so on. 鈥淥ur cases were necessarily snapshots,鈥� he emphasizes, 鈥渂ut we knew we really needed to be in the moving-picture business. Change, change, change. We had to rewrite old cases and write new ones, constantly.鈥�
It was a labor of love that continues today.
The entire US venture capital industry added up to a mere $1 billion or $2 billion back in the early 1980s鈥斺�渒ind of a rounding error,鈥� Sahlman observes鈥攚hereas today, it鈥檚 a hundred times as big, with additional trillions of dollars sloshing around in private equity and other pools of funds. Meanwhile鈥攁s both a cause and an effect鈥攁n enormous entrepreneurial revolution has been unleashed. More and more people have access to more and more money to try out more and more ideas.
So yes, money talks鈥攁nd loudly. But the revolution also has psychological aspects that are harder to quantify and equally profound. As a society, and certainly in the business class, we鈥檝e come to think about entrepreneurs differently. 鈥淭oday,鈥� Sahlman says, grinning, 鈥渢he implications of failure are de minimis. Assuming that you didn鈥檛 lie, cheat, or steal, or personally cause the collapse of the venture, you can fail and get away with it. In Silicon Valley, you fail, and you don鈥檛 even have to change parking spaces. You just go back into the building, new company, and your Herman Miller chair is still there. And you鈥檙e not called a failure. You鈥檙e called聽experienced.鈥�
And certainly, Sahlman and his colleagues can claim some share of the credit for that revolution. They thought systematically about a phenomenon that didn鈥檛 seem to lend itself to structuring鈥攁nd succeeded. They immersed themselves in a world in which every single deal was unique鈥攁nd almost by definition, unprecedented鈥攁nd figured out some underlying dynamics that explained, and sometimes even predicted, success and failure.
Not an onion, certainly. Maybe an avocado: a fruit with a skin that seems tough but still allows for easy bruising by outside forces, with a certain amount of highly perishable reward below鈥攄epending on whether you choose well in the first place鈥攁nd a core that promises growth and renewal.
Depending on whether you grow it right.
Takeaways from Entrepreneurial Finance
Each of the 10,000-plus veterans of Entrepreneurial Finance has his or her own list of lessons learned in the course. Here are just a few:
Cash is king.聽More cash is better than less cash. Cash now is better than cash later. Less risky cash is better than risky cash.聽Don鈥檛 run out of cash!
Use your cash to get smart.聽Use your resources to buy time to structure tests that reveal value-changing information. What can go right? What can go wrong? How can you manage reward and risk?
Hone the deal.聽Who gets what amount of cash at what time? How is risk allocated? What are the incentives of all parties to the deal now and given reasonable scenarios into the future? Who will be attracted by the deal? What can be inferred from how people respond to the deal terms? What are the future consequences (at all levels) of current decisions?
Pick great people.聽Who among your potential co-venturers is skilled, flexible, and honorable? How can they help when smart VCs pay more attention to the聽team聽than to the initial value proposition. Build the team that will buy you credibility鈥攁nd of course, get the job done.