Secrets of raising venture capital

The Olim twins started their online music store by borrowing from their parents. They were soon raising huge sums to feed the fast growth of their successful CDnow. Here they tell us how.

By Jason Olim, Matthew Olim, and Peter Kent

In March, CDnow, the worldÕs first online music store, announced a $522 million merger with rival N2K. The Olim brothers, who started CDnow in 1994, have millions at stake in a battle for dominance in Internet music sales. Only a few years ago, the now 29-year-old twins were maxing out DadÕs credit cards to get their fledgling company going.

CDnow, which had net sales of $50 million in 1998, helped revolutionize the retail world. It created the model of vast selection, low prices, and immediate delivery that has formed the foundation of other Internet retail successes like bookseller Amazon.com. Jason and Matthew Olim started CDnow with a mere $1,500Ñall they had. Barely out of college, they operated the company from their parentsÕ basement in Fort Washington, outside Philadelphia.

It took only a few months before orders started coming steadily. The company grew, and had no competitors for the first year or so. But then the twins heard that large, established media companies were thinking about starting their own online music stores. They knew theyÕd need a serious infusion of cash if they were to stand a chance against well-funded competitors, so they sought venture capital. In a chapter of their new book, The CDnow Story: Rags to Riches on the Internet, told in JasonÕs voice, they explain what they learned about how to get investment money and use it to expand fast.


Money was a huge problem for us. For a long time CDnow survived on the float from CD salesÑthe money we took in from our customers that we didnÕt have to pay out immediately to Valley Records, our music distributor, and various other suppliers. The interesting thing about the float, though, was that it was constantly growing. Thanks to the incredible growth in both the market and our revenues, the float just kept getting bigger, affording us latitude. In any other situation we would have gone out of business in a hurry. But the money we owed for Òlast monthÕs salesÓ was always considerably less than the money we took in Òthis month.Ó We could grow, even though we didnÕt know exactly what we were doing, because the market would forgive us our mistakes.

Of course, we did have a clear visionÑwe knew what we were doing in our store. We had a solid idea of what the customers wanted, while our competitors didnÕt, and this made all the difference. We just had no real business experience or training. The float covered our bills, but because we didnÕt have enough money for anything else, we were forced to do things that distracted us from our main goal, and we were unable to invest in things that would have helped us grow larger, faster.

Our initial investment was the $1,500 I had saved for a guitarÑplus our time. Matthew worked full-time on the project right from the start, 15 or 16 hours a day. For the first few months I continued to work at Soft•Switch, an e-mail software company, and contributed my income to the business.

Soon we took another $12,000 out of savings. When that ran out we used what is euphemistically referred to in the finance business as Òadvances from related partiesÓÑwe borrowed money from Mom and Dad. Initially we borrowed $8,000. Later, there were the credit cardsÑa lot of credit cardsÑsometimes ours, sometimes our parentsÕ. At one point we owed $80,000 on credit cards, several of them in DadÕs name. Of that, $10,000 was on one MasterCard alone. Banks kept sending us applications, so we kept applying. It was a wonderful surprise when we discovered that we could raise cash just by filling in a form. I remember Matthew running into the office one night waving a piece of plastic, with an excited look on his face, saying, ÒHey, we just made $5,000!Ó This is a familiar story to many entrepreneursÑyou find the money where you can.

Profit was plowed right back into the business, but we always needed more. We were growing so fast that although each monthÕs income was greater than the cost of last monthÕs CD shipments, we still had to spend more money than we had. We were in a race to build the InternetÕs top music storeÑwe had to promote the store, advertise, buy more computer equipment, hire more people, constantly expand. Growing at a 300 percent annual rate takes a huge investment!

 

Fruitless meetings

When we first began the company we didnÕt consider venture capital. We didnÕt even know much about it until our second employee, Andrew Sternthal, told us about a lawyer who worked with small companies looking for capital. I called the attorney, and learned that he worked with investors known as ÒangelsÓÑ individuals with their own money to invest in small projects that tickled their fancy. We began looking for venture capital in the summer of 1995.

I spent many fruitless hours meeting with people in suits and ties. I didnÕt understand enough about the business of venture capital, or even the lingo. And, looking back, I think it would have been wise to cut my ponytail and put on some shoes. We all padded around the office in sneakers or even bare feet, sometimes just in socks, and we joked about the guys who would turn up in shiny black shoes and expensive suits. ÒOoh,Ó people would say, Òthere are adults in the building!Ó

A series of venture capitalists turned up at our offices in the old house. They would ask all sorts of questions about the business, but I didnÕt know what answers they were expecting. So I simply told them the truth: This is what I see, this is what weÕre doing, this is where weÕre going, this is what I think the issues are, hereÕs the competitive situation. TheyÕd sit there and nod, and then theyÕd leaveÑno feedback, no advice. ThatÕs what I really resented; theyÕd listen but never give anything back. TheyÕd never say: ÒIf you do x, y, or z, then call us back,Ó or tell us to address particular issues, or point out weaknesses in our business plan. I would even ask for advice, but perhaps they took that as evidence of weakness and inexperience.

Another problem was that I was asking for too little money. I started off asking for about half a million dollars, then later about a million, but thatÕs not enough for most venture capital companies. If thatÕs all you need, they figure, thereÕs not much potential there. I should have been asking for $2 million or maybe even $5 million.

I almost convinced one of the angels, Jim Saltzman, to invest in us. We had reached the stage where we were offering 30 percent of the company for a $500,000 investment (what a deal that would have turned out to be!), and I was negotiating whether or not it would be subordinated debt, or preferred, or this or that. But I had no experience at this game. I knew nothing about how such deals were structured, what was fair, what normal percentages were. I was relying for advice on a law firm, friends of my parents. They understood this sort of negotiation so they could point us in the right direction to some degree; nonetheless, I was in way over my head.

At one point there was a lawyer for Saltzman sitting across the table from me and negotiating the main details of a deal, but I felt there were problems in the terms they were offeringÑthe amount of control they wanted over the business, issues of payments in arrears, and so on. I asked for a specific salary of $55,000, plus bonuses based on profitability. I thought of this as the first bid in the negotiation, but I was surprised at the response. ÒWe wonÕt go for that,Ó the lawyer said quite bluntly. ÒWhat will you go for?Ó I asked. He wouldnÕt say. Instead he bluntly stated that if I kept pushing for things like this, they werenÕt interested in the deal. I threw him out of the office. ÒYouÕre the lawyer for an experienced investor,Ó I said. ÒYou do these sorts of things all the time. IÕm just a 26-year-old entrepreneur whoÕs never done one of these deals before. If you canÕt come back to me with a reasonable offer and a reasonable explanation of what youÕre doing, then you shouldnÕt be negotiating with me, so I think itÕs time you left.Ó

I got a call from Saltzman the next day, saying heÕd take the lawyer off the project. But it was too lateÑI really didnÕt feel I could continue with the investment deal. Nonetheless, we remained on good terms. Saltzman was still interested in working with us somehow. HeÕd invested in other technology companies and done well, and he saw CDnow as a good opportunity. Eventually he loaned us $250,000 for six months. In return he got a warrant to buy stock in our company; he eventually bought two percent of the company, so his loanÑwhich was repaid in full with interest, of courseÑturned into an excellent investment.

Near the end of the ÒangelÓ negotiations, we got a call from a distributor who wanted to introduce us to an investor. It was literally a few hours after our Òno-shop periodÓ had expired (we had an agreement not to talk to anyone else until weÕd finished negotiations). So I called the guyÑa businessman named Alan Meltzer.

Meltzer was the founder of a music distribution company called Music One StopÑthe biggest CD distributor in the United States in the 1980s. He had merged Music One Stop into Bassen, another large distributor, to create Alliance Entertainment. Alan had left them a few years before we met him. He loaned us $100,000, so we didnÕt need any more investors...for a few months, at least. Later Alan would buy part of CDnow for $1.2 million.

 

Wild ideas

Our quest for money continued with more visits to and by venture capitalists. I was invited to a money event at Carnegie Hall in New York City, so I put on my shoes and went along. (I was amused by the idea of visiting Carnegie Hall, and went around asking everyone how to get there, knowing the answer would be Òpractice, practice, practice.Ó) The event consisted of a bunch of retail people who wanted money, talking and eating and drinking wine with a bunch of people who had money. The food was provided by some of the companies in which the venture capitalists had already invested. WrapsÑburrito-type thingsÑwere big that year; the money men had invested in a company that sold wraps, and so that was one of the meals they served.

I got chatting with one venture capitalist who explained the concept of a ÒrealÓ Internet business, which his company was working with. It was a well-known shoe store with a lot of money in the project. ÒTheir concept,Ó he explained, Òis that you buy 12 pairs of sneakers, and you get one pair free. What are you doing like that?Ó he asked me. He continued to provide me with his boundless experience: ÒUnless you have an idea like that, you donÕt have a business.Ó

This guy had no idea what the Internet was all about, evidently. But that was fairly common. The venture-capital companies couldnÕt make up their minds whether we were retail or technology. The retail guys said we were too much into technology, and the technology guys said we were too into retail. Nobody seemed able to see our business model as a completely new sector: a form of retail that used a high-technology sales channel.

There are people out there who are arrogantly ignorant, and people who are humbly ignorant. I knew that I was ignorant to some degree, that there was a lot I didnÕt know about business. But I was willing to learn. And I did know about the Internet and running an Internet store. But there are thoseÑmany of them working in venture capital, it seemsÑwho are willing to force their ignorance on you. Consequently, you might hear a lot of stupid things if you spend time around venture capitalists: Buy 12 pairs of shoes, get one free. The assertion that the only way to build a business was on a single gimmick could be based only on a complete misunderstanding of what we were trying to do.

There was another problem with the venture capitalists, too, however. I seemed to give the impression of being, well, a wild man. IÕm tall and, one might say, imposing, and at the time I wore a ponytail. Whenever someone visited, there was also a good chance that I would be barefoot. I seemed to scare off investors, giving them the impression that I would be hard to control. I simply didnÕt give the impression of being a businessman.

One venture capitalist told me this outright. The man had been recommended to me by a lawyer friend who had done some work for us. We met and, as usual, I didnÕt get much of a response; he sat and listened, then stood up and said goodbye. I called my friend and said IÕd like some kind of feedback. He called the money man, who finally contacted me. ÒYouÕre a wild man,Ó he said. ÒYou wonÕt listen to anybody, youÕre uncontrollable.Ó That didnÕt sit well with me. It was completely unfair. I built my business through listening to what people wanted in an online music store, and I couldnÕt understand how this man had gained this impression of me. I did, however, cut off my ponytail late in 1996.

 

What it really takes

It wasnÕt until someone taught me the secret to venture capital that we finally raised money. The man who knew the secret had been my boss at Soft¥Switch, which I had since left. He was a venture capitalist and a friend of Joel Sussman, who at that time was a consultant for CDnow (now heÕs our chief financial officer). Joel got the two of us together, and the man explained what it takes to find venture capital. He said the secret words that opened the door were: ÒTell me what I want to hear. Understand whatÕs important to me.Ó My excitement about the business had been scaring people off. I came to the conclusion that my presentation worried investors because, in my excitement, I was looking too far into the future. It suggested that I had aims other than making them money, that I would not listen to their advice, and so couldnÕt be relied on to look after their interests.

Venture capitalists want you to forget about your concerns for a moment and explain whatÕs in it for them. They want you to tell them how the business is going to grow and how itÕs going to make money. You have to tell them that youÕre in the business you really want to be in, that youÕre not planning to get into another business down the road. You have to make them understand that youÕre focused, that the business will succeed, and that they will make money. You have to make sure they believe that youÕre ready to do what it takes to be successfulÑand that includes listening to them and taking their advice.

This may sound obvious once itÕs clearly stated. But when youÕre explaining a business to someone itÕs all too easy to lose focus on what they care about, and get swept away with your own excitement about your wonderful new enterprise. Always remember the unstated question: ÒWhatÕs in it for me?Ó This investor had said, in effect: ÒLet me tell you whatÕs important to me. Then you can speak about that.Ó

ThereÕs another thing to understand about venture capitalists: They look for reasons not to invest in something. They have certain sums of money that they must place somewhere, and there are plenty of places to put it. They often donÕt know much about the businesses theyÕre going to invest in, so they have to cull the ones they feel wonÕt return profit. When they talk to you about your business, theyÕre looking for reasons to reject you.

 

Big money

The really big money finally started rolling in late in 1997, when BT Alex Brown Inc. found $10 million in venture capital for us from a group of investors that was led by Grotech Capital Group and included Keystone Venture Capital. Then, in February 1998 we went public and raised $75 millionÑa huge sum, hard to imagine after all the scraping weÕd been through.

This doesnÕt mean weÕll never need to find more money, but it has enabled us to invest in some extremely powerful promotions, and to increase our staff considerably. Of course, now we have another constituency to satisfy: stockholders. Stock prices are all over the place, and Internet stocks in particular can bounce up and down very quickly. Andy Grove, the chairman and former CEO of Intel, was quoted in the magazine Business2.0 as saying: ÒWhatÕs my ROI [Return On Investment] in e-commerce? Are you crazy? This is Columbus in the New World. What was his ROI?Ó I understand just what he means.

ItÕs amazing what money can do. Once you have the cash, you can do all sorts of big things you never imagined, like advertise on TV during the Grammy Awards, or hook up with partners with huge cloutÑcompanies such as the Yahoo! Internet search firm and Rolling Stone magazine.

Internet commerce is the beginning of the most important economic revolution of the 20th century, perhaps the most important economic movement since the Industrial Revolution. ItÕs going to take huge investments to stake a claim on this new frontier, but I believe that in the long term the sums invested will be nothing compared with the gains.

 

Jason and Matthew Olim are the founders of CDnow. Peter Kent is the author of numerous computer and business books. This article is excerpted with permission from The CDnow Story: Rags to Riches on the Internet, Top Floor Publishing, Lakewood, CO, 800-247-6553, http://topfloor.com. ©1998 Jason Olim, Matthew Olim, Peter Kent.


The OlimsÕ tips for creating a useful Web site

Untitled Document CDnow was the worldÕs first online music store. Its Web site set the standard for simplicity, utility, and impact that other Internet retail giants-to-be like Amazon.com followed. In a chapter of their book, ÒThe CDnow Story: Rags to Riches on the Internet,Ó the Olim twins offer advice on how to create a super company Web site. Excerpts:

ÒWe didnÕt get distracted by the complete nonsense that all too often passes for advice in the Web-design world. We didnÕt set out to create a ÒcoolÓ site, we tried to create a site that would provide the three important things that we believed our customers were looking for: selection, information, and convenience. That, in itself, is cool.

ÒOnce youÕve got the site to function the way you want it, then you can make it attractive. But to place form over function is a big mistake. People wonÕt buy from you because your Web site is attractive. They buy because of selection, information, and convenience. If cool gets in the way of these three aims, cool is out!

ÒThatÕs not to say we donÕt want an attractive site. The judicious use of album covers on the main page, on category pages, and on the recording-artist pages makes our site attractive. We use a variety of graphic-design elements to brighten up the site, too. But we limit the size of these images to make sure that pages load quickly.

ÒThere are lots of little tricks you can use to make a Web site attractive without overloading it with bloated graphics and gimmicky animations. You can use background colors in tablesÑthese add almost nothing to the size of files to be transferred. You can use a few small images spread around a page, instead of one large image. You can use black-and-white images, which can be saved in very small files. A good designer can do a lot with very littleÑand we employ the best. The site has to be easy to use, and serve the visitor, otherwise thereÕs no point in doing it.Ó