Starting Up in a Down Economy

Case Study No. 1: How Method Weathered the Dot-com Bust * A recession is commonly defined as two consecutive quarters during which the country's gross domestic product shrinks.

It is too soon to say whether the economy is in a recession now. When they look back on the early days of their start-up, Adam Lowry and Eric Ryan remember that a lot of potential investors laughed at them. The Bay Area, where they were living, was awash in Internet start-ups. Each week in 2000 brought another glitzy launch party or news that the scantest of business plans had attracted venture capital. Even office landlords were demanding equity from their dot-com tenants. Lowry and Ryan, who wanted to start a company to make -- of all things -- humdrum household products, were decidedly out of step with the times.

"You had the sense that there was this real historical thing going on in the region, even if it was not going to end well," says Ryan.

Still, Ryan and Lowry felt they had a good idea. Method, their start-up, wouldn't sell just any household products. Its soap and cleaning supplies would be made from environmentally friendly ingredients and would come in chic packaging. Compared with the products of giants like Procter & Gamble (NYSE:PG) and Clorox (NYSE:CLX), Method's merchandise would be hip. So the partners passed on interesting and potentially lucrative job offers and pooled $100,000 in personal savings to get started.

You know what happened next: The go-go New Economy abruptly ran out of steam. Dot-coms ran out of money, layoffs were rampant, and the entire city of San Francisco seemed to suffer from an economic hangover. People started to worry openly about a recession.

Like most business owners facing hard times, Lowry and Ryan focused on their costs. They were expert bootstrappers, mixing cleaning solution in a bathtub, bottling it themselves, and driving around town to restock shelves. They would accost any store manager who would listen to their spiel. They returned to some stores three and four times before they got an order, and little by little their sales pitch improved. And the partners noticed something else: Compared with the situation a year before, when there seemed to be five start-ups for every idea for a business, the competition was relatively muted.

"Starting a business in a recession is like vacationing in the off-season," says Ryan. "It's a little less crowded, and everything starts going on sale."

By spring of 2001, Lowry and Ryan had gotten small-batch production on track and had hired a CEO named Alastair Dorward. But Method's debt stood at $300,000, split among the three men's personal credit cards. Payments to their vendors were three or four months past due, and at one point Lowry and Ryan had just $16 left in the bank.

"We had to appeal to the inner entrepreneur of each of our vendors," says Lowry. "We had to sell them on the fact that Eric and I could do something that had never been done before."

Lowry and Ryan also tried again to raise money, and with VCs falling out of love with dot-coms, they found that there was more interest in their idea. In early September 2001, the partners received a term sheet for $1 million -- a sum that would allow Method to get current on its bills and then begin to expand. They were set to close the round on September 11. Needless to say, the deal didn't go through right away; the partners finally closed in November. And there were some serious strings attached.

Lowry and Ryan would receive $550,000 up front. Of that money, the legal fees associated with the transaction would eat up $110,000, and $300,000 would go to pay outstanding vendors' bills. That left Method with $140,000 in capital. To get their hands on the remaining $450,000, Lowry and Ryan were obliged to meet a key milestone: They would have to add distribution to 800 stores by March, which was just five months away.

The tenuous nature of Method's financial situation was underscored at the dinner Lowry, Ryan, and Dorward hosted to celebrate the deal. The partners gathered their investors plus their lawyers and accountants at an expensive restaurant in San Francisco. When the bill came, Lowry's credit card was declined. Then Ryan's card was declined. And Dorward's. Their backup cards were declined, too. "It's a good thing Eric knew the owner of the restaurant," says Lowry. "We convinced him we were good for it -- that that guy over there was about to give us a million bucks."

Method did make it into 800 stores by March -- though just barely. When Lowry and Ryan got the remainder of their Series A funding, they paid off old accounts and then jumped right back into fundraising mode. With the recession in full swing, venture capitalists were being very picky when it came to making new investments. But Method, which had been ignored barely 18 months earlier, was suddenly a Bay Area darling.

"It was really interesting," says Lowry. "We used to be completely off investors' radar screen, but when the bubble burst, people were clamoring for us. Our business plan wasn't some sort of ad-based or online thing that was hard to understand. Our model was, 'Hey, we're going to make this cool product, and if you think we can sell a lot of it, then it's a good investment.'"

Being able to raise money in 2001 undoubtedly put Method on the growth path. By 2006, the company had $71 million in sales, and today the founders are pushing to reach $100 million. But Lowry and Ryan look at the period before they raised money, when they struggled and nearly drowned, as pivotal. In retrospect, the fact that they had to hone their pitch in countless meetings with store managers and vendors was fortuitous. They were practiced enough that by the time their big break came -- pitching Target for national distribution -- they didn't blow it. Which raises the question: Did the recession actually make Method better? The founders think so. As Ryan puts it, "The hungriest wolves hunt best."

**ON SALES **Downturns are actually a great time to sign up new accounts. That's because companies are examining every expense for ways to save. If you can offer a better price than their current vendor, you will have a decent chance of winning their business. -- Ryan McCarthy

Case Study No. 2: As Others Quit R&D, RF Micro Devices Forged On In early 2004, Jim Kemerling came to visit Bill Pratt in his stately Greensboro, North Carolina, office. Kemerling had been laid off two years earlier and had started a company called Triad Semiconductor. He had a groundbreaking idea -- a chip that could be customized easily -- but he was having a hard time getting the technology right. Two years in, he still didn't have a finished product.

Though he was an ambitious engineer, Kemerling appeared to Pratt to be plainly discouraged. So Pratt told him the story of how he had founded his company, RF Micro Devices. Eighteen years earlier, Pratt was running a research and development division for a big semiconductor company. When the business posted its first loss, in 1991, Pratt's facility was shut down.

Fortunately, his severance was generous: Besides the equivalent of a year's salary and benefits, his bosses transferred to him the rights to the technology he had been developing -- tiny chips for cell phones. They also let him use their office rent-free and sold him testing equipment for a bargain price of $70,000.

A month later, Pratt and a colleague named Powell Seymour launched RF Micro Devices. Even with the intellectual property and free offices, Pratt's first year in business was disastrous. The design work would cost several hundred thousand dollars at least. Dozens of acquaintances had pledged their financial support, but they all begged off when it came time to cut a check. Very quickly, the partners drained their severance and then maxed out their credit cards.

"That was very preoccupying," Pratt recalls. "We had families to feed."

Then the company's prototype literally went up in smoke. Pratt and Seymour were in the lab, designing a chip for a Japanese cell phone company. One minute, the chip was there, visible under the lens of their microscope. The next, it was gone. The minute structure had gotten so hot that it had simply disintegrated. The partners saw humor in the situation -- "We had this great product that would disappear at the most inopportune times," Pratt jokes -- but their client wasn't amused and withdrew its order.

In early 1992, just before their severance ran out, Pratt and Seymour landed $1.5 million in venture capital. The terms of the deal were pretty dreadful -- the partners gave up 60 percent of the company to their investors -- but they desperately needed the cash. The next four years were marked by more snafus and bad breaks, including a client that canceled a project only after RF had delivered 100,000 parts.

But persistence finally paid off: The company turned a profit for the first time in 1997, the same year it went public. In a funny way, Pratt says, the recession was a blessing. Because few companies were investing in product development at the time, RF Micro Devices could labor over its chip design without worrying about competition. And when the economy took a turn for the better, Pratt's technology was ready to go, while other semiconductor companies, having scaled back their R&D efforts, were now forced to play catch-up. "It gave us a window of opportunity," Pratt says.

Today, RF boasts $1 billion in annual revenue and more than 3,200 employees worldwide. Having struggled for many years before becoming a success, Pratt heard echoes of his own story in Kemerling's. When they were fired by a big semiconductor company, Kemerling and his partner, Dan Wrappe, indulged in self-pity for a few days before founding Triad, in a business incubator at Wake Forest University.

"We thought we would go out, talk to customers, and start taking orders," Kemerling says. The reality was a little more complicated than that. Customers told Kemerling and Wrappe that they wanted something like a chip template that could be easily tailored for each client, which would cost half as much as the standard chip and shorten the amount of time needed for customization. Kemerling worked on a prototype that met these specs, but it was taking time, and his credit card bills were ominously high.

Having been in this situation, Pratt advised Kemerling to stay focused on R&D. He agreed to join Triad's board and to help Kemerling raise money. In 2005, Triad finally perfected a customizable chip that could be produced in six months -- half the industry norm -- for half the standard price. Triad's chips are now used in a variety of products, including industrial machinery and heart monitors, and the business is on track to turn a profit by early next year.

"It's very important for entrepreneurs to have a mentor," Kemerling says. "Starting a business is a lot easier when you have someone who's done it before and can walk you through the process."

ON HIRING If a local company has layoffs, call its HR department. You may be able to work with the company or with its outplacement agency to identify seasoned workers who would be interested in joining your start-up or working for you on a contract basis.

ON BOOTSTRAPPING Barter. Existing businesses will be looking for ways to put their excess capacity to use and may be willing to work with you. Online bartering exchanges, such as BizXchange (bizx.com), have listings for services like IT help and logo design. -- Nadine Heintz

Case Study No. 3: Hard Lessons Learned From Clif Bar's Fast Start Gary Erickson couldn't have cared less about the state of the economy as he drove across the Bay Bridge in September 1991. What he needed was a name for his new energy bar. The next day, he was going to a cycling industry trade show. Bike shops figured to be his main retail outlets, so this was a chance to get buzz. Without a name, he might as well stay home.

Then, as he made his way to the office of his package designer, it came to him: Clif. It was his father, Clif, who had instilled in him the love of the mountains, who started him skiing at the age of 4, who was responsible for all of his outdoor passions, from rock climbing to bike racing. It was perfect. And so Clif Bar was born.

Although he didn't know it at the time, Erickson started his business in the middle of a recession. The downturn began in July 1990, four months before it dawned on Erickson that he could make a better-tasting energy bar than PowerBar, which had the market to itself back then. By the time he shipped the first Clif Bars, in February 1992, the recession was officially over, although the hard-times mentality lingered long enough to ensure Bill Clinton's election that fall. "The economy, stupid" may have been as much of a boon for Erickson's start-up as it was for the Clinton campaign.

Erickson found, for example, that contract manufacturers were delighted to do business with him. Would that have happened if they hadn't been worried about their own sales at the time? Perhaps. It would certainly have been more difficult for him to have signed them up if the economy had been booming and they had had all the work they could handle. He could have found himself pleading with vendors to take on a start-up that might not have survived long enough to pay its bills. And unlike the owner of an established business, who faces a number of distractions in a recession, Erickson was free to focus on developing the bar, marketing, finding distributors, and so on.

When you're starting out, you naturally worry most about the possibility of failure, and so you devote your energy to avoiding it, which means making sales and generating cash. What people seldom prepare for is the possibility of success, especially when times are tough. (Boom times are different. In the late 1990s, it often seemed that most entrepreneurs were already figuring out how to spend the money from their future IPOs.)

And yet success brings with it dangers of its own, as Erickson soon discovered. Today, Erickson says a "cocktail" of factors made it possible for him to start Clif Bar back in 1991. Without any one of them, he probably would not have launched the business. To begin with, there was the wholesale bakery he had founded in 1986, at the age of 29. He named it Kali's Sweets & Savories, after his grandmother, Kalliope. It made Greek calzones and cookies, all from his mother's recipes. He sold them to specialty food retailers in the Bay Area, such as Peet's Coffee.

By 1991, the bakery employed 10 people and was doing close to $300,000 a year in sales but had yet to break even. Erickson estimates that it was losing from $10,000 to $20,000 per year -- a situation that was no doubt aggravated by the recession. He worked nights and drove the delivery truck on Tuesdays and Fridays. By day, he continued to work full time at a bicycle company. To help manage the business, he brought in Lisa Thomas, a bookkeeper for his brother's foundry. Grateful for her involvement, he made her a co-owner of Kali's, with 50 percent of the stock.

Erickson doubts he would have been successful with Clif Bar without the education he received at Kali's. "Your entrepreneurial M.B.A. begins when you start your own business and sign a check, hoping it doesn't bounce," he says. "If Kali's had never happened, I'd probably still be working for a bicycle company."

Of course, that job in the bike industry was another ingredient of the Clif Bar cocktail. "I was involved in industrial design and manufacturing there," he says. "I ran a facility with 40 people. I knew how to manage a P&L. So none of that scared me. And I understood the market that PowerBar had developed, so it wasn't hard to visualize that I could draft off their wheel, as we say in bike racing."

Bike racing was the last part of the cocktail. One weekend in November 1990, a friend invited Erickson on a 125-mile ride that turned out to be 175 miles. He had brought six PowerBars with him. After he ate the fifth one, Erickson found a 7-Eleven, where he devoured half a dozen powdered doughnuts. Right then, he had an epiphany: He knew he could make a better-tasting product.

Erickson spent the next 15 months developing his energy bar while Thomas looked after Kali's. Working with his mother in her kitchen in Oakland, he tried various flavors and used his bike-riding buddies as taste-testers. Meanwhile, he found a bakery that had the necessary equipment to make the bar and was eager for the business. Once he had figured out the bar's size and shape, he went to work on the packaging and kept at it right through the trade show in September 1991, which was a big success. More than a thousand bike shops expressed an interest in carrying Clif Bar. It took another five months to launch.

By then, Erickson had two distribution agreements in place, but his expectations were modest. "PowerBar was doing probably $6 million or $7 million a year at the time," he says. "I'm thinking, Gosh, if we could grab 20 percent of their market share, we could get to $1 million, maybe even $2 million, and laugh all the way to the bank."

In February 1992, Erickson shipped the first 30,000 Clif Bars to his distributors -- and the product took off. Sales totaled $700,000 in the first year and $1.2 million in the second. In 1994, he blew past his initial goal of $2 million in sales. And around that time, he discovered his first costly mistake. It involved his two distributors. Erickson felt their performance was faltering, and he wanted to bring distribution in-house. The problem was, he didn't have a contract with either company. Out of naivete, haste, or reluctance to spend money on a lawyer, he had done both deals on a handshake, and the distributors' understanding of what they had agreed to was different from his. He wound up settling with both of them at a total cost of $2 million.

The second mistake took a longer time to reveal itself and was much more serious. In launching Clif Bar, Erickson had neglected to set it up as an entity separate from Kali's. As a result, he and Thomas each owned 50 percent of the stock. The full consequences of that decision -- or nondecision -- became apparent in 2000, when Erickson turned down an offer of $120 million for Clif Bar. Thomas wanted to accept it, and as an equal partner, she could have brought down the company if Erickson didn't accede to her wishes.

In the end, parting ways with Thomas cost him more than $80 million, including interest, legal costs, and noncompete fees -- all for a mistake that could have been easily avoided in 1991. "I could have left her as 50 percent owner of Kali's and told her this was a new business, which it was," Erickson says. "Instead, I just rolled Kali's into Clif Bar."

Lessons in entrepreneurship don't get much more expensive than Gary Erickson's -- at least not for people whose companies survive. Despite the burden of the buyout, Clif Bar managed not only to survive but to prosper. This year, Erickson expects sales to top $200 million. Succession is the big question on his mind these days, although he does wonder about the possible impact of a third recession in 18 years. Somewhere, after all, another start-up could be taking aim at Clif Bar, and a recession might be just what it needs.

ON PRICING Offer a discount to customers who pay up front. They save money, while you get what every start-up needs, which is cash flow. (You may want to cut a deal with only one or two customers, however, to avoid being tagged as a discounter forever.)

ON TERMS If you can afford it, offer customers generous terms. If they are used to paying their vendors in 30 days, offer 60-day terms. Their current suppliers are unlikely to be as flexible, which means you will be offering the client something unique. -- Bo Burlingham