June 19th, 2008

The penny machine

in: Communicate, Funding

An entrepreneur walks into the maple-paneled boardroom, glances around the table at the well-groomed investors gathered there, and reaches into a large leather bag. He pulls out a strange machine, roughly two feet high by one foot wide, sets it carefully on the table, and plugs it in.

The room is expectantly quiet.

“Does anyone have a penny on them?” asks the entrepreneur. The general partner raises an eyebrow as one of the junior staff hands over a faded copper piece.

“Now watch.”

The entrepreneur inserts the coin into the top of the machine, and pulls a small lever. There is a low-pitched whirring, a pause, and then a shiny new nickel tumbles into the small shelf at the bottom of the machine.

The only sound in the room is the ventilation system, cooling the warm Palo Alto air.

“That’s a neat trick,” says the silver-haired general partner, straightening up in his seat and grinding his brown Mephistos into the new rug beneath him. “Do it again.”

He hands the entrepreneur another coin.

The entrepreneur slides the second penny into the top of the machine, and again pulls the lever. Out tumbles another nickel.

“You’ve got a bag of nickels in there,” accuses a slightly disheveled technical analyst. “Open it up.”

Wordlessly, the entrepreneur releases a small clasp on the side of the machine and swings it open. Within are a series of tubes and wires, but nowhere is big enough to conceal nickels. The analyst looks mildly offended, but the general partner is on the edge of his seat.

“How many pennies can I put in there an hour?” he asks.

“It takes five seconds to cool down, so you can insert 720 pennies an hour. That’s $36 in nickels for a profit of $28.08 an hour, with a margin of 80 percent.”

The general partner leans back in his Aeron chair and gazes out across 280, into the Woodside hills. He pauses for a minute. “Can I put nickels into it?” he inquires.

“I’ve tried it with dimes. It works. Produces neatly folded dollar bills. I haven’t tried anything more than that yet, but I’m hoping it will handle fives,” replies the entrepreneur.

“How many can you make and run at once?” asks the partner, oblivious to the rest of the room.

“I think we can have five hundred machines running around the clock.”

“One more question,” says the partner, “and I think we have a deal. Why can’t someone else build one?”

“I have intellectual property protection on the core mechanism, and I’ve signed an exclusive agreement with the US mint to be the only producer of legal currency.”

Of course, this isn’t a real VC pitch. But it’s as close to perfect as one can get. We can learn a lot from the penny machine, and it’s a metaphor I use a lot to get startup CEOs thinking like investors.

The penny machine has an obvious money-making ability. You put in money, and more comes out. People are familiar with what a penny is. While no business is that clear-cut, the CEO needs to be obsessed with making it as straightforward as possible why the venture will yield revenues.

The entrepreneur had reasonable answers to key questions: How big can the business grow, how good can the margins get, and what kinds of barriers to entry does it have.

The presenter engaged the audience, and let them help him tell the story. They were smart people that asked the questions he wanted, and he showed them that he’d anticipated their questions by providing slightly more detail than they asked for without going into too much depth.

There was no need for a detailed technical explanation at this stage. Later, the investors would certainly go over the technology carefully to ensure that it wasn’t illegal, immoral, or outright trickery. But this meeting wasn’t about that. Opening the machine up served as a simple proof that everyone in the room understood well enough.

The entrepreneur didn’t set a valuation. He gave the investors all the details they needed to form one of their own, based on revenue potential, margin, costs, and so on.

Startup CEOs seeking venture capital would do well to remember the penny machine. It’s a good way to ensure they’re thinking like a VC. Every time your pitch strays from the simplicity of this meeting, it’s a warning sign that you need to go back and tighten it up.

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