Category: Blog Post

If you’ve seen this 90’s Apple ad, you’ll be familiar with the saying that “people who think they’re crazy enough to change the world are the ones that do.”

As investors, we hear a lot of crazy ideas. While some crazy ideas are quite brilliant, some are just… crazy. *Cue the Bacon Alarm Clock*

I was hoping to share an investor’s perspective on crazy, disruptive ideas and how we try to apply some logic to them. This is some general, high-level thinking. We’re not getting into the nitty-gritty of how companies necessarily work today.

Value and Other Incentives

What’s the value proposition for the product you’re offering your customers? Is it genuinely impactful? There are two common sayings I use for a gut-check on the value offered by a new product.

• Is it better, faster, cheaper?
• Is it oxygen, aspirin, or jewelry?

The second one is likely the only one that needs explanation — you’ve probably heard the first before.  This saying gets entrepreneurs or investors to think deeply about the true level of need customers have for a product. For jewelry, the product may be something you like or enjoy, but could certainly do without. For aspirin, the product genuinely alleviates a pain point, but again isn’t 100% necessary for your day-to-day. For oxygen, you quite literally need this product — you couldn’t imagine your life without this product. I like to think of this as if it’s more of a spectrum rather than a sheer categorization; if you ever figure out how to make a business out of selling oxygen, call me. 

There are many blog posts out there about how to think about value, but not enough to think about the other part of the equation: the resistors.

The value offered by a product must be great enough to overcome the opportunity cost of the customers time, money, and, if they’re switching from a previous product, the entire value of that previous product. When you dig into the neuroeconomics of how a customer makes this decision, it’s quite obvious that people don’t really like change — as nice as that would be. Brand loyalty is a very powerful thing, all thanks to the croc brain.

Market Readiness

Bill Gross has quite a popular Ted Talk on how timing is likely the most important factor for startups — and it’s true! However, doesn’t that sound a little vague? What does that really mean? Well, it means a lot of things, and frankly, it’s pretty complicated. I’ll try and explain it in a simple way. Let’s consider these factors, also known as PESTLE analysis:

This analysis is meant to be up for interpretation, so I’m not going to break every factor down in great detail. I’m just going to really focus on two: Social and Technological. 

Social speaks to people’s behavior. If your product requires people to drastically change their daily lives, and that change is unwanted, it might be a bad call. Take traffic, for example. There are a lot of solutions out there today to “solve traffic” (e.g., MagLev, the Boring Company, Autonomous Vehicles, Scooters, etc.). If your solution is to have people work remotely, perhaps they don’t want that. Perhaps they like going to work and being with their coworkers. Perhaps they get more work done there. Your product has to fit with the customer’s life, not cause an unwanted dramatic change in it.

Technology is a bit of an easier subject. I mean, ask yourself, is this idea technologically feasible? Can we even build it?

However, sometimes it can get a bit more complicated or indirect. A great example I like to use here is Instagram. Instagram is likely one of the best timing stories. Instagram would have never worked if it were not for the smartphone. As a website, it would have been a total, painful failure, which is likely why the website has limited features. The ability to quickly take a high-quality photo and upload it to social media was a really powerful thing. It was something that was wanted, people already owned smartphones and were taking pictures, Instagram simply provided a place to share them. The supporting technology was already in the palms of all the users, and folks were starting to take more pictures already because of their always handy camera.

So, now that we’ve gotten here ask yourself: is my product really valuable? Is the market ready?

If you answered yes to both those questions, go build the damn thing. 

Building models for really young companies is distinctly different from what you may be doing in investment banking or similar financial jobs — especially if the company is pre-revenue and has no historical financial data. The purpose of building models at this stage is to run a simple sanity check.

You really just want to see if what the entrepreneur is proposing makes financial sense. Here are a few examples of what might be considered insane:

1. Projecting sales volumes that exceed total market size (even, say, 10% market penetration is often a bit too hopeful)
2. Assuming incredibly low churn/ incredibly high conversion
3. Not including R&D expenses
4. Growing revenues rapidly without hiring a proportionate amount of talent

Most startups are burning cash at the beginning. The sales volumes aren’t supporting the expenses, and sometimes they haven’t been able to get their variable costs low enough to even make money at the unit level. This is normal. In fact, many VCs use a popular

metaphor to explain the financial life cycle of successful startups: the hockey stick. When you get into venture, this J-curve will become all too familiar. Every entrepreneur wants to say, “well we’re burning cash now, but eventually we’re going to take off like a rocket ship.” That’s a nice story, however often it’s not much more than just that.

 

So, when you’re constructing a model, you’re really trying to just tell a story, and ask a few critical questions. What does the company need to do to become cashflow positive? What expenses are associated with meeting those objectives? Are these assumptions reasonable? What should their financing strategy be? What’s a reasonable return multiple I can expect from my investment in 5-7 years? What’s the IRR for that? How much will my equity be diluted down the line if I don’t do my pro-rata?

Once you’ve passed this sanity check, you’ll need to evaluate some of their metrics from what you’ve built.

Maximum Negative Cumulative EBITDA

Calculating how much negative cash flow a startup accumulates from their projections can help you create a financing strategy. The timing of this is also critical. It is actually quite normal for this number to get quite high for early companies. They should expect multiple rounds of financing. However, it’s important to make sure they have an appropriate amount of runway to grow their revenues, say 18-24 months. Failure to meet milestones and grow revenues when raising a premature round could lead to excessive dilution, which isn’t good for the entrepreneur or the investor. You need to be able to anticipate this so that the entrepreneur raises the appropriate amount of capital, not too much or too little.

However, this metric can also be a bit excessive. If the projections here amass to a huge number that isn’t typical of the industry the startup is in, their raise for a bridge to A round could look a little more like a pier.

Gross Profit Margin

Many tech companies are often losing money quarter over quarter, but you want to make sure that there are significant cash flows. The free cash flow a startup create gives the company independence from outside financing. Significant expenses in R&D or marketing can be supported by their own sales volume, rather than raising large rounds over and over. Considerable margins may also give a startup the ability to quickly generate cash, or even rebound from non-dilutive debt.

Seasonality

Is there any degree of seasonality to sales? For example, we all know that pumpkin spice latte’s sell more in the fall/winter. If there is a serious amount of seasonality to your sales, how are you accommodating that? Do you use short-term contracts for some of your employees? Are you oversubscribed on fixed costs that could cause a serious issue when sales fall?

Capital Efficiency 

How much revenue is generated from capital spent? In other words, if I put in $3M into a deal, how much revenue will the entrepreneur be able to generate with that? Low capital efficiency could also cause an unnecessary amount of financing rounds, which will dilute your equity share.

 

These are all boxes that need to be checked. Often, first-time entrepreneurs don’t look too far into the future and can be a bit heads-down focused on product. It’s your duty as a potential investor and equity partner to not necessarily dock an entrepreneur for not thinking of some of these things, but to advise and create a strategy that passes the sanity test.

Often, entrepreneurs have a great team and product, but not the best strategy — and that’s ok! A plan can be changed, but a team cannot.

If you’ve read my posts, you know that I’m a firm believer that good tech investors know product. It’s absolutely essential.

Bill gross gives an excellent Ted talk covering some of the top reasons that startups succeed.

The talk goes into detail discussing which factor may be most important, but I believe that they are all essential. Investors need to know why a product is unique and ultimately defensible.

I’m also a huge proponent of pursing education online for free or at least for a low cost. Today, I’m simply sharing an episode from one of my favorite podcasts, the Machine Learning Guide by OCDevel, which covers what degrees/certifications are available to you and how they are perceived by employers.

https://itunes.apple.com/us/podcast/machine-learning-guide/id1204521130?mt=2&i=1000381369979