Innovation Footprints

What if . . . ?

Venture Capital

Why You Should Apply The Less is More Rule of Seduction When You Meet an Investor

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Two weeks ago I had a meeting with an entrepreneur who has built an interesting startup. It was our first time meeting one another to discuss his startup. Before we met I had spent about 10 to 15 minutes studying the startup’s website. After doing that I sent him a list of questions that occurred to me based on other startups I had studied in the past which could be seen as pursuing a solution to the same problem he seeks to solve. You may have encountered his product on the internet without realizing it. I am impressed by what he has accomplished so far given the resources with which he started. 1I am thankful to readers who saved copies of the original version of this post before I deleted the first iteration of Innovation Footprints. This version of the post is largely the same as the original. I made minor changes to increase clarity and reduce misinterpretation.

Don’t you want to know what I think is the best thing about our meeting?

We talked for about 90 minutes. I wanted to make sure that I did not leave our conversation before learning enough about the market he is pursuing, the problem he is solving, the product he is developing to solve that problem, the team he has formed to do those two things, and the basic characteristics of the financing round that he is now raising. I also wanted to make sure I understood whether or not he has found any customers willing to pay for the product in its present incarnation. If yes, I wanted to understand what their reaction has been so far.

But, I digress.

It was not until we had discussed his work for well more than an hour that it hit me. What they are doing could be disruptive to a legacy set of tools and product suites that people have relied on for many years now to do some rather important work – making sense of proprietary and non-proprietary data. I should know, I used to spend my working hours trying to do just that using tools that were a pain to work with then, but they were the best we had.

I do not know if he planned it that way. He did not tell me that he thinks he is working on something that could be disruptive. Rather he gave me an exhaustive explanation of the problem he is trying to solve and the various customer segments that have found what he is doing valuable enough so far that they have started paying the startup for access to the product. He connected the dots for me, and helped me get to my own realization about how disruptive his product could become without ever once using a phrase for which I have learned to keenly pay attention. He did not say: “I am going to disrupt the . . . industry.” By doing so he preserved his credibility. I will explain why.

I am teaching my self about entrepreneurship, startups, innovation and venture capitalism. To do that I am relying on the body of knowledge that many other people have accumulated. I read other blogs, I read books, I try to do more listening and less talking when I am in the company of other early stage startup investors, and I enjoy chatting with entrepreneurs.

Here are two things I have learned.

What is a startup? Steve Blank defines a startup as a temporary organization that is formed for the purpose of searching for a scalable, repeatable, profitable business model. A startup becomes a company after it has completed that search. You already know that this process is usually set in motion because the startup is solving a problem, and is doing so on the basis of an innovation or a set of innovations that is the consequence of someone’s thinking, observation and experimentation.

But how might one think about innovation? What kinds of innovation should I expect to encounter?

Brant Cooper and Patrick Vlaskovits answer that question in their book; The Lean Entrepreneur. They describe two forms of innovation. The first form of innovation is Sustaining Innovation. It is characterized by; a problem that is well understood, a market that already exists and is well defined and predictable, resultant performance improvements that are incremental in nature – lowering costs by a small percentage for example, customers that already know they want this solution, and it is reliant on traditional business processes that already exist within that industry or that can be adapted from an adjacent industry.

The second kind of innovation is Disruptive Innovation. It is characterized by; a problem that we know exists but that is poorly defined and not well understood, the potential to create a new and
unpredictable market, outcomes that are dramatic and potentially game-changing, customers that do not yet know they want the solution being developed, and non-reliance on already existing business methods in that industry or adjacent ones because such methods will fail.

So there is much that is unknown when it comes to startups and their ability to disrupt an industry. Entrepreneurs and founders of early stage startups who make the claim to investors that their startup will disrupt the dynamic already at play in their industry make a very bold and audacious claim that they often cannot yet defend. Why? Because they simply do not yet have have enough quantitative or qualitative data that would prove the point.

The lack of evidence is not necessarily a bad thing. After all if the evidence about the disruptive potential of the startup were so obvious for everyone to interpret, I might not have been offered the opportunity to discuss possibly making an investment in the startup. But, I think founders and entrepreneurs make a mistake when they eagerly declare, early and often, how they will disrupt something or another. Often, we just do not yet know. Here are some observations to illustrate the point:

The startup may be solving a problem, but how do we know that it is solving the right problem? If the solution is truly disruptive, how can we predict how customers will behave when they encounter the solution the startup has developed? Do we even know if we have identified the right market, and how can we say how that market will react? Early adopters are probably not representative of the market. The startup will not attain a profitable business model wholly on the basis of early adopter enthusiasm. Since we can’t expect to rely on traditional business methods how do we know what we have to do in order for the startup to become a company?

I know, I am making the case that there is a lot that is uncertain. But that is okay. Uncertainty is not necessarily a bad thing. The entrepreneur should be seeking investors that want to help the startup answer the questions every early stage startup must answer, in exchange for the potential financial rewards that the investor might realize once the startup accomplishes its mission.

The next time you are meeting an investor to discuss your startup don’t start by telling that investor how you will disrupt your industry. In fact, don’t mention disruption at all. Simply describe the problem you are solving – in sufficient detail that they fully understand the pain that your potential customers are experiencing because they do not yet have your solution available to them. Explain why you decided to start solving that problem – may be you were motivated by what you learned at a prior job. Tell them about your assumptions. Tell them about your hypotheses. Tell them about the experiments you have performed up to that point. Show them the results of those experiments, and describe some of the conclusions that you think can be drawn from those results. Tell them about your value proposition. Let them connect the dots. Most case studies that discuss disruption are backward looking. You want the investors you speak with to look into the future and imagine what might be possible if you work together. Explain why you believe you will succeed.

To get me thinking and believing that your startup might disrupt its industry try applying the less is more rule of seduction, because the more strident your declarations that you will disrupt your industry the more skeptical I become.

References   [ + ]

1. ↩ I am thankful to readers who saved copies of the original version of this post before I deleted the first iteration of Innovation Footprints. This version of the post is largely the same as the original. I made minor changes to increase clarity and reduce misinterpretation.

After Our First Meeting, How To Help Me To Quickly Learn About Your Startup and Maybe Say Yes

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Let’s be open. I am not going to make up my mind about investing in your startup after just one meeting. And, I definitely am not making my decision wholly based on looking at your pitch deck.

I like to do my own homework. So I think of your pitch deck as only a starting point.  After I have met you I will spend some time describing what it is I think you do for myself. I will state the problem you are trying to solve in my own words. Once I feel I understand what you do, I will spend a lot of time trying to understand why your customers would care. Does it save them time? Does it make them safer? Does it make them more money? Does it make them happier?

After this I want to understand if there are alternatives to the solution you want to bring to market. What will people do if they don’t adopt the solution you have developed? I know. You have no competitors. Still, I need to confirm that for myself. If what you are doing is as important as you say it is, is it possible that no one else has thought along the same lines as you before now? May be they failed. That is fine. I just need to study and understand what happened. Doing so will give me a better sense of the biggest challenges you might face given what we know. Things change. Technology. Competition. Preferences, and tastes. Regulations. But, at least we would have a historical guide to refer to. I am not wedded to history, nor do I think history has to repeat itself. Nevertheless, I’d still like to know what steep hills and sharp corners we might encounter.

Next, I want to get a sense of how much value people assign to the solution you have developed. Is their perception of the value high, low, or somewhere in-between? I want to understand if they will perceive that its value increases the more they consume it, or if they will feel that it has less value the more they consume it. I don’t want to invest in a startup whose customers feel that they get decreasing satisfaction value from its product as their cumulative consumption increases. It may be too early to know the exact pricing for the product, but I want to gain a sense of the dynamic that might develop around how you price your product and how the market responds.

Then I’d like to get a sense of just how big you could get. Is this an opportunity that is purely domestic? Why? What prevents you from getting bigger? Are there regulations that prevent you from expanding? Is the barrier cultural? If there’s a barrier how might we overcome it once we start gaining traction and have overcome the growing pains that your startup will encounter?

But this is all preliminary due diligence that I will do before I determine if I want to proceed with further discussions. So here’s how you can help me.

Surely there’s some research that you read while you were in the planning stages, before you committed to actually building your startup. Share it with me. If there’s a website that covers the area in which your startup will be focused, send me the link. Send me enough information so that I can be more efficient in finding answers to the questions I will be thinking about as I engage in my internal-debate about the merits or demerits of an investment in your startup. It will move things along faster.

I am not asking for anything confidential, just public information. I was studying a startup doing something really unique related to a device billions of people use. Its technology could also be used by the businesses that serve content to those devices. That mode of content delivery has exploded as these devices have become more powerful.

After our first meeting, I dug around on Google and found two great research reports from Oracle that answered the most important questions I had been thinking about. It took me a few hours of searching the Internet, and reading through some other crappy material before I found that report. Of course I was delighted, and then I asked myself why the entrepreneur did not simply send that, and possibly another one – a report that’s published by Qualcomm every year – to me. Those two publications answered all the initial questions I had, but it took a few days before I found them, read them, and got all the answers I felt I needed.

What would I do if I were you? Prepare a draft email that you can send potential investors 1Katie Smith Milway describes The Art of Irresistible Emails at HBR. It would look something like this:

Dear Brian:

Thanks for meeting with me to discuss my startup. I look forward to hearing from you once you decide on next steps. I have attached a copy of our investor presentation. I have also included some links to publications and articles that will quickly help you find independent data and information about the problem we are solving and the potential for us to build a profitable business doing so.

1. The Problem

1. Link #1

2. Link #2

3. Link #3

2.The Competition

1. Link #1

2. Link #2

3. Link #3

3. The Customers

1. Link #1

2. Link #2

3. Link #3

4. The Market

1. Link #1

2. Link #2

3. Link #3

5. The Technology

1. Link #1

2. Link #2

3. Link #3

I hope you have more questions after you have had a chance to study the information that you will find there. I’d love to discuss your questions and give you a better sense of how we have interpreted the data and the information that we have studied so far.

Entrepreneurial Founder

This email should sit in your drafts folder, so that you can copy and paste it many times. Send it to every investor that you meet. Your goal is to help me see things the way you see them. At the end, I might disagree with you anyway. That is okay. But, at least using the approach I have suggested, you helped me gain perspective based largely on some of the same information you have relied upon up till now. You are now better positioned to try to interpret data and information that I might have misunderstood simply because I do not know the topic as intimately as you. In other words, you are more likely to succeed in walking with me as I try to make the intellectual journey that you and other people with whom you are building your startup have presumably made numerous times already.

A calculus textbook I owned in college 2I still own it. I know exactly where it is had this Chinese proverb inscribed inside the front cover:

I see and I forget. I hear, and sometimes I remember. I do, and it becomes part of me.

Notwithstanding your list, I will still do a lot of research on my own. The difference is that thanks to your email, I will know what to look for from the outset. That means I can spend more time thinking about your startup and your team, and less time reading crappy research reports. All else equal, that ought to tilt the scales in your favor.

References   [ + ]

1. ↩ Katie Smith Milway describes The Art of Irresistible Emails at HBR
2. ↩ I still own it. I know exactly where it is

What I Worry About When I Am Studying A Startup

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One of the things I really like about my job studying and investing in early stage startups is that I am constantly learning something new. This is true especially when I am encountering a startup for the first time, and begin to study polished and slick pitch materials on my own, listen to the entrepreneur deliver a pitch, or independently try to educate myself about the basics of the problem that the startup is trying to solve. 1I want to thank Jess Hsu, Shally Madan, and Seymour Duncker. They sent me copies of the original post which I lost when I deleted the first version of Innovation Footprints. I updated that post with some more details, but the final message is the same.

Ultimately, my goal is to make a decision; invest or don’t invest. Then I have to decide if I know enough to determine if that choice is final, or if I am open to revisiting the question when there’s more evidence to add to what I already know. Even if I do not want to invest now, I may want to have the option of investing in the subsequent capital raise.

This is an in-exhaustive list of the things I worry about during the process. 2I read Bill Clark’s 10 Things You Need To Check Before Investing in a Startup regularly and often when I got my first assignment to make an investment decision about a startup. I have adapted Bill’s checklist which was published online by Mashable on May 24, 2011. Bill’s post is here: http://mashable.com/2011/05/24/startup-investing-checklist/.

  1. Do I understand the market? It can’t be the case that every startup is going to disrupt its industry. Do I understand the human side of the equation that the startup feels will work in its favor? Why will people behave in the way that the entrepreneur needs them to behave? Why might they not behave in that way? Where’s the evidence? If the startup is not selling to consumers I like to speak with a handful of customers to hear what they say about the product.
  2. Do I have a sense of the people behind the startup? Being an entrepreneur is extremely difficult. I have never been an entrepreneur myself, but I watched my mom try and fail to build small businesses from home when I was a child. I know how hard she worked because I helped her for 3 or 4 hours every day when I got home from school and before I did my homework. Eventually she started a school with three children from our garage. She has been running it for more than 25 years now, and it has grown to a population of hundreds of students. Building a startup requires relentlessness, resilience, optimism, determination and adaptability. I need to have a sense that the people behind the startup are committed to the vision for which they want my buy-in. I need to gain a sense of the working relationship between the members of the team, and the group dynamic at play. If there is more than one founder, I need to believe that they share an absolute trust and respect for one another. I also need to feel that they are capable of “fighting good fights” in the pursuit of building a successful startup, shepherding their investors capital, and fending off competition. I need to understand the motivation that is driving the team to do what they say they are going to do. “I would trust my co-founder with my life.” is music to my ears. When it is possible I try to spend some time with the team in a non-work social setting. I believe that a startup team that plays together and laughs together will probably stay together.
    • I like to know that there is someone in charge of setting the strategic priorities for the startup, of course this person must consult with the team and then distill the teams’ ideas and input into a coherent strategy. In this instance, I see attempts to “manage by consensus” as a signal that I ought to proceed with caution.
  3. Do I understand the different ways in which the startup can make money? Better yet is the monetizations strategy believable? I may disagree with an entrepreneur’s reasoning behind delaying implementation of a monetization strategy. But there has to be a monetization strategy, and some evidence to support it. To this end I’d like to get a sense of what the sales pipeline looks like. I get really tentative if it appears there’s no one willing to buy what the startup is selling. Any sign of customer interest is better than none. Things may change, and quickly too, but I want to know that there is some one outside of the startup’s circle of close family, friends and early adopters, who is willing to buy and use the startup’s product or service.
  4. Do I have a sense of the competition? Is there a startup that “has no competitors”? I don’t think so. An entrepreneur that tries to convince me that the startup I am studying has no competition might as well be jumping up and down, waving a red flag. No one has an unlimited amount of money. How quickly might a direct or indirect competitor respond if this startup is super successful and starts to steal revenues, customers and market share? How will small, medium and large competitors respond respectively? Can I identify any substitutes? What of complements? Could bundling our product with a complement or several complements help ward off competition? How easy is it for competitors to replicate what the startup has developed? What happens if they succeed? To this end I’d like to see an inventory of the startup’s intellectual property – patents, if applicable. But definitely trademarks, servicemarks, copyrights. I’ll want to know what the secret sauce is that will keep this startup ahead of the competition.
  5. Do I believe that the advisors have really been adding value? Or is this all just a hoax? If at all possible, I prefer to speak with two or more advisors. It is a red-flag if a startup has several advisors who are “too busy and important” to speak with a potential investor, particularly if that investor is going to take a significant portion of the round, say 25% or more.
  6. Does the cap table leave any room for new investors without the need to haggle strenuously with old investors? I once saw a cap table which showed that existing investors owned nearly 90% of a startup I was studying. Given the amount of money it had already raised over previous rounds and the progress it had made to that point, I realized that we would have had to enter into difficult negotiations with the fairly large group of previous investors. The CEO would have effectively been arbitrating a negotiation between new investors and existing investors. I would rather negotiate with founders and management. I also prefer to invest in startups in which the majority of equity is owned by founders, management, and employees. It is a good sign if I find an adequate stock option pool; 10%- 15% with a healthy portion yet to be issued.
  7. Do the financials suggest anything I should be concerned about? Money in the bank is every early stage startup’s lifeblood. Before the startup begins earning revenues, I want to know that the team is disciplined about how it budgets, allocates and spends cash on the startup’s activities. I also want to ensure that there are no big liabilities on the books. Some level of accounts payable is not a big deal. A huge accounts payable balance serves as a red-flag that requires me to ask some questions.
    • In addition to financials I want to review any operations data that the founding team relies on to monitor how things are going. How actual results compare to the startup’s historical projections will help me paint a picture for myself of how effectively the team has met its self-imposed targets in the past. I recognize that such data can be fudged, or even completely spurious. So, I’ll spend some time determining how much credence I should place on the data that I am given. I will be trying to check for internal consistency and coherence with other data that the startup has provided.
  8. What are the plans for the capital raised? Details, details, and even more details. I like to see a budget.
  9. How long before lack of money becomes a problem again? Time spent raising money is time not spent building the product and its features, or winning customers, or communicating the startup’s value proposition to the market. I need to know how long the money that has been raised will last. In the best of all worlds, the money raised should be enough to last about 18 months. That gives the team 12 months to focus on solving the startup customers’ problems, and then delivering that solution to the market before the CEO’s attention must be turned back to fund-raising. Naturally, no one will complain if the startup runs out of cash because growth in customers and revenues accelerated far beyond management’s expectations. That’s a “high class problem” – I like high-class problems, very much.
  10. Do I understand the legal documents? I have to know what I am getting into. I spend a lot of time reading the legal documents for myself, and I’ll have an attorney review them as part of my due diligence. This often results in a headache for me, but it is essential that I avoid any land-mines that might be neatly hidden somewhere. At a minimum I’ll want to see:
    • Documentation related to any previous financing rounds.
    • Contracts, letters of intent, memoranda of understanding, distribution agreements, partnership agreements – if the startup claims to be gaining traction with customers, and partners.
    • Employment agreements with key team members; inventions and other IP, confidentiality, non-disparagement in the event of separation, etc. etc. Knowing the details helps, but in certain cases I’ll accept a summary if there’s a compelling reason to do so. For example, some international startups may run afoul of employment laws in their home country if they were to provide the full details to a foreign investor.
    • I want to know about any legal disputes.
  11. What can I find out about the founders, board members, and current investors through some basic research on the internet using a search engine? This small but important step can save you from making a catastrophic mistake. At the very least, you’ll be operating from a position of knowledge rather than one of ignorance. One might even go as far as checking court and county records. Depending on the size of the investment, it might make sense to have a professional run a full background check on the key people at the startup.
  12. Do I feel rushed into making a decision? If yes, then I will always decide not to invest at that time. Early stage investing is already risky enough as it were. I do not need to increase the risk and uncertainty. On the contrary; I need to minimize it by taking intelligent risks. I try to avoid making bad investments by saying “no” when I feel rushed and pressured to take shortcuts.

Trust, but verify. That’s the principle I apply. Hopefully that will keep me around long enough to hit a few home-runs. 3Really early stage startups are unlikely to have everything I have discussed above. I have encountered startups when there was just a founder with an idea. Then the due diligence is mainly on the idea and on the founder’s ability to make it reality.

References   [ + ]

1. ↩ I want to thank Jess Hsu, Shally Madan, and Seymour Duncker. They sent me copies of the original post which I lost when I deleted the first version of Innovation Footprints. I updated that post with some more details, but the final message is the same.
2. ↩ I read Bill Clark’s 10 Things You Need To Check Before Investing in a Startup regularly and often when I got my first assignment to make an investment decision about a startup. I have adapted Bill’s checklist which was published online by Mashable on May 24, 2011. Bill’s post is here: http://mashable.com/2011/05/24/startup-investing-checklist/.
3. ↩ Really early stage startups are unlikely to have everything I have discussed above. I have encountered startups when there was just a founder with an idea. Then the due diligence is mainly on the idea and on the founder’s ability to make it reality.