Investors get it wrong most of the time. A few suggestions from a serial entrepreneur to better returns.

In a recent post I read about outsized growth that some VCs would like startups to achieve for the sake of the investors and their backers.  I wondered if that model is still feasible or wise in this new and accelerating world we find ourselves in.

Upon reflection of 17 different startups with 10 in an operational role I have been involved in, I also wonder if it ever made sense based upon the path most startups take when they grow very fast – sometimes too fast.  Let me start with a little background to help make my case.

Background

In the book, Exponential Organizations, I read that in 1995, a founder in Silicon Valley would need about $15M to start a company which mostly went to build server stacks, purchase software and hire staff to configure and manage all that technology, as well as to write new code. By 2004, that figure dropped to about $4M and today with now-established capabilities such as cloud computing and social media, that same effort costs less than $100,000.  That is an incredible drop in needed resources in a very short amount of time.   Founders do not need as much capital by a long shot than what was required even 10 years ago.  I think that is a mixed blessing which I will get to shortly.

With cloud computing and social media capabilities used widely, the reach of any startup is about 100X what is used to be.  This means that a founder can test out an idea’s market feasibility well before s/he writes one line of code or the dreaded business plan (not sure why anyone needs a business plan at this stage since there is yet no business to plan).  With the reduced risk and need for capital, the investor may now have a harder time buying into a company for enough stake to make it worth it to them.  This also has to be balanced with the desire for the founder to keep as much ownership as s/he can afford.

Since about 9 out of 10 startups fail to provide a meaningful return, this creates a dilemma for the investor.  How do they pay back the participants in the fund with such a low hit rate?  In order to do that, one strategy I have learned is the investor has to place enough “bets” and encourage them to all grow at a tremendous pace(thus needing much more money and increasing the investors stake in the company – an inherent conflict of interest I believe) in order to spread the risk around enough companies to get a pay day from one or two to make up for all of the other losses.

On the other side, the founder, in most cases, wants to grow in a way that they need as little capital as possible to maintain a higher ownership stake.

These two parties who are supposed to be on the same team seem to be in conflict from the outset.  This creates a problem for most founders as they are on the wrong end of a power dynamic.

There has to be a better way for most founders and investors to align their desired outcomes to increase everyone’s odds of a meaningful return.

A Better Way?

How can the investor increase the odds of picking a winner? (Please note that the founder has a responsibility as well but I am not focusing on that part of the equation here. I have in other posts – here and here.)

 A high-level outline of what I propose to the investor follows:

  1. Vet the team NOT based upon (your opinion of) the quality of the idea, but based upon the founding team’s passion to solve a particular customer problem(s).  I have seen too often, a founder, when meeting with potential customers, staunchly defend his idea to the prospect and ignore the feedback (or worse not even ask for feedback) or try to show them the error in their thinking.  Many times, during a debrief I hear these words “they just don’t get it”.  My rule of thumb here is that if you hear yourself saying “They just don’t get it” 3 or more times in a short period of time, you have the pronoun wrong.  It should be “We” and the team needs to ask themselves why they are doing this.  Caring about the customer and his/her problem should be paramount so the idea can evolve organically.
  2. Make sure the problem/market is big enough. (This is S.O.P I know.) The investor should provide this info and the investor should corroborate it.
  3. Except on the rare occasion when it is warranted, DO NOT give them more than enough money to perform product/market fit interviews.  Nothing else, do not tell them to hire a hot shot sales guy or rock start developers or a PR firm…nothing.  I suggest giving them enough so they do not have to continue to eat Ramen noodles and maybe can enjoy a break if they would like it without worrying about next month’s rent check or having to move back into their parents house but that is it.  Hungry and humble are the founder’s best assets at this point.
  4. Make them read Customer Development by Cindy Alvarez andLean Startup by Eric Ries.  The aforementioned ExponentialOrganizations is not bad either. They can and should learn from the multitude who have gone before them.
  5. Have them provide their rationale for picking their particular market segment.  I would also recommend you have them share with you the other one or two runners up segments.  This will hopefully help them not to anchor on the one they chose and give you, the investor, other avenues to pursue as you do you separate due diligence.
  6. Provide them with a specific set of metrics you would like to see on(at least early on).  Let them know they have 2 months to talk to at least 20 people in the identified target market.  When they report back, you and they can decide if further study is warranted, they should move to a different market or they should start building out an minimum viable product or service.

Here are some suggested metrics/deliverables to choose from (this list in not exhaustive):

  • Whole solution understanding
  • Business model – at least two ideas on how to make money
  • Cost and time to build MVP
  • Solid understanding of the economic buyer, the user and the ecosystem.
  • Their differentiators to win in the market.
  • New idea identified that warrants further study and funding (i.s., talk to 20 more people and come back to the table for a second round of validation)
  • Have them fill out a business model canvas if they have identified a defensible position to judge the landscape
  • Identified partners; measure the strength of the relationships
  • Advisory board members; have they surrounded themselves with complementary and useful people to help address the needs of the market and build a healthy and scaling company?
  • Clear process explained on how they make difficult decisions. Bay of Pigs vs. Cuban Missile Crisis learnings of Kennedy is a good analogy..
  • What criteria they use to hire key people
  • What is their model for execution of priorities
  • How will they know when they have the right people in the right seats doing the right things.

If you and they see some promise in an area where they have passion to continue then provide them enough money to take the next step below.  If not, have them start again or go back and start on something new.

  1.  If they have a well-defined market with enough customers that are wiling to pay enough money to create a business they can scale, this is where you can decide to make the big investment to build out the team, fund go to market strategy, etc. I think this will take between 50 and 100 conversations (unless they are lucky) to be reasonably sure that they are onto something.
  1.  Once they begin to scale the company, the leaders now need to begin to turn their attention to making sure the organization is much more self-reliant, so they can focus on longer term planning.  Hiring an advisor/coach or several executive coaches to help the CEO and the team to build a healthy and profitable business over time can prove a wise investment.  Reading and learning from books like those mentioned in this article are also useful. I have many other suggestions on my website.

Mixed Blessing

I believe that it is almost too easy now to start up a company. I recently read and heard that there are about 11,000 new companies started every hour!  I find this hard to fathom but regardless of the exact number, there are still a lot of new businesses springing up everywhere, all-the-time. I would argue that there are too many in fact.

Ideas are a dime a dozen. Just because you have a good idea, DOES NOT mean you should start a company.  An idea is just the start and I believe is actually not the beginning of what the founder should be thinking about first but that is a story for another time as well. One has to look at many other factors before they embark on a journey that so few make it through and even fewer do well.

I also strongly believe that there are too many that fail for reasons that are, in hindsight, almost entirely preventable had the founder and investors sought help from others early on.

Easy to start, easy to fail.

Conclusion

I am not sure how prevalent this process is in the marketplace. What I am sure of it that it is not ground-breaking nor revolutionary.

In my 25 years of working with startups, I have found that it is rare to see leadership teams, investors and board members employ these sustainable and proven practices.  I hope this changes as I believe the current model wastes a lot of money and time.  It also too often ignores the customer and the employee – two key stakeholders in the success of any company.

My advice to investors of fast-growing companies:

  1. Invest in the founding team’s passion to solve the problem, not their passion for the idea.
  2. Invest in fewer companies and provide them general guidance on how to search for the best business model and product/market fit.
  3. Don’t give them too much money. Keep them hungry and innovative but don’t put them in survival mode all the time as poor decision will be made – a fine balance for sure.
  4. Focus more on internal than external metrics.  Remember that revenue grows faster than talent and masks internal problems.
  5. Stress accountability as an important discipline.
  6. Make sure your leadership teams stay close to the customer. That is, make sure each and every one of them talks to a handful of customers every week. It is amazing how grounded this will keep the team and how it will accelerate learning and growth.
  7. Help the founder to be scalable.  Many get lost along the way for predictable reasons.  Just because they were great at the beginning of the process, does not mean they can make the changes to get them through additional growth phases.  Help them up or help them out as you see the signs when they are out of their depth.

“What got you here, won’t get you there” – Marshall Goldsmith, Mark Reiter (another good book)

Good luck starting and scaling up!  These non-financial investments are why great companies become great and too many others are left behind or are lost forever.  I am not advocating that the investor do all of these things personally but, in their own best interest, they should be providing guidance in these areas so their teams can grow and keep their investments growing as well.

I look forward to your comments.

Be Exceptional!

(catalystgrowthadvisors.com; bill@catalystgrowthadvisors.com)

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