Last week a friend high 5’d me and congratulated me on finally writing a non-portfolio related post. I shrugged...
Entrepreneurial businesses can be described in as many different ways as there are entrepreneurs. Over the last dozen years I’ve reviewed thousands of entrepreneurial businesses and listened to thousands of entrepreneurial presentations in the context of my role as a venture capital investor as well as a lecturer on entrepreneurship at universities around the world.
Each business, and each entrepreneurial team, is unique. Evaluating each is always case-specific. At the same time, over my career I have synthesized a simple structure that I always use as the framework for evaluating a new opportunity. Both the structural components and the order in which I evaluate them are specific and intentional.
The framework I use has 4 basic components, in order of importance:
1. Entrepreneurial team (51% importance)
2. Market opportunity (30% importance)
3. Initial product/solution (10% importance)
4. Financial plan (9% importance)
I intend to draft several deeper posts with my specific thoughts on each of the areas above. For today, I’ll make a few comments on the framework itself. As an important caveat, I only invest in business-to-business companies seeking extremely high rates of growth (10x in 5 years). As a result, my framework and the comments that follow do not necessarily apply to consumer-oriented products or businesses, nor to “lifestyle” businesses.
First, the order of my framework is very important to me, and the relative percentages of importance reflect my priorities. At the beginning of my investing career, I believed the conventional wisdom that the team is the most important component of any start-up. An important, but nuanced, point to make here is that a team is more than just a collection of individuals. Any fan of sports, performing arts, or other area of human endeavor will recognize the distinction; yet too often, entrepreneurs relegate the description of their team to a collection of resumes or bullet point qualifications at the end of a company overview.
A dozen years and three dozen investments later, I still believe the team is the most important component for startup success. Now, however, I believe it is more important than all the other aspects of a start-up combined. The difference in the caliber, capability, chemistry, and culture of the entrepreneurial teams in which I have invested has nearly always been the driver in the difference in outcome. Margaret Mead’s famous quote applies best here: ”Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has.”
The second-most important criteria I use in evaluating a startup is the market opportunity. I find that this area is the least-well-understood by most entrepreneurs. The most common mistake is to first present the product or technology solution that the team has developed, and then present the market opportunity naively as “the set of customers who need this product.” This thinking is the inverse of the way customers think. Customers do not think about what product they need. Customers think about a pain point in their lives - a problem they need to solve. The most compelling entrepreneurial market opportunity is one in which (a) a meaningful number of customers have such a pain point, (b) customers are _aware_ of the pain, and believe that living with the pain is not an option, (c) customers have the financial resources and authority to purchase a solution to the pain, (d) the price customers are willing to pay and have the ability and authority to pay is a price that significantly exceeds the cost of a solution, and (e) those customers that meet criteria (a) thru (d) can be efficiently identified, segmented, contacted, sold, supported, and then referenced by additional customers.
The mistake I see over 90% of entrepreneurs make is to start with an axiomatic assumption of the product or solution they will deliver, and then try to convince me (and themselves) that the above criteria (a) through (e) are true for that product or solution. The approach used by fewer than 10% of entrepreneurs, but nearly all my successful portfolio companies, is to start by finding the most compelling area where (a) through (e) are true, and only then look to develop a product or solution that targets that opportunity.
Just to underscore this point, when I teach entrepreneurial business courses, I never have the students create a business plan. Traditional business plans tend to reinforce a damaging mindset in which the purpose of an entrepreneurial business is to create a product or solution. As Peter Drucker so elegantly said, the purpose of a business is to create and serve a customer. Of course, building great products that “delight” their customers is a fundamental requirement to serve that purpose. But too many entrepreneurs confuse themselves with Steve Jobs, and confuse the product they have built and they themselves love with a solution that customers will love. As a result, I find it helpful to instead require students in the courses I teach to create a “market opportunity analysis,” not a business plan. In this document, the entrepreneurs are forced to take a customer-centric view and describe all of the (a) through (e) criteria above in great detail - without ever proposing a possible solution. The point is to focus on whether it would be compelling to develop a solution, regardless of whether it’s possible to create a solution. Only if it is truly compelling, is it then worthwhile to consider what the range of solutions might be.
Following this logic, the actual initial product/solution developed by an entrepreneurial team is of far less importance to me. This should not be confused with the lack of a compelling technological or product development advantage; these are essential. However, the chosen implementation of a product or solution should be driven by what will serve and delight customers by solving their problems and eliminating their pain. A rare historical handful of entrepreneurs, like Steve Jobs, have an innate and intuitive ability to predict what that type of product or solution will look like. Most successful entrepreneurial teams don’t have that capability, but can approximate it with a disciplined and efficient “customer development” process in which they immerse themselves in a customer-centric mindset and constantly iterate on the product or solution until it achieves success in the customer’s view. The concept of “customer development” was introduced and popularized by Steve Blank, who teaches in the Stanford Technology Ventures Program that I helped develop, and Steve’s books, lectures and blog are must-read materials for all entrepreneurs.
On a tactical level, I have found it to be surprisingly challenging for entrepreneurs, particularly those with science and engineering or manufacturing and operations backgrounds, to truly shift to an opportunity-analysis-before-solution mindset. Often, they are literally unable to cognitively embrace the idea of exploring a market opportunity unless or until they have already chosen a specific product or solution. Even among experienced venture investors, I find rare the ability to articulate a startup’s market opportunity potential _before_ first anchoring on the specific product or technology solution. I believe this subtle but profound order-of-priority mistake is the driver of most venture investing mistakes, and the resulting poor performance of the industry over the last 10 years.
The final criteria on my evaluation framework is an analysis of the financials. For some reason, seed- and early-stage investors continue to overemphasize the importance of 3- or 5-year financial projections from startups, and then choose to analyze the attractiveness of a venture based on the provided results. In the advertising industry, especially pre-Google-pay-per-click, it was often said that “50% of all money spent on advertising is wasted, and the biggest problem is that nobody knows which half it is.” Similarly, at least 50% of all financial projections made by entrepreneurial companies are completely wrong - and the biggest problem is that, at the outset, neither the entrepreneurs nor investors have any idea of which half it will be.
I do find the creation of financial projections to be valuable, but not for the reason of evaluating their attractiveness. Instead, I find the exercise forces entrepreneurs to deeply think through their assumptions about market opportunity sizing, pricing, sales cycle length, sales channel costs, distribution costs, support costs, marketing costs, etc. Even those assumptions will turn out to be 50% wrong - but by having thought deeply about them ahead of time, the entrepreneurs will be much quicker than competitors to realize where the mistakes are and where the real answers lie. As a result, my financial analysis inevitably turns into a veiled method of evaluating the entrepreneurial team, my most important criteria. The best teams clearly articulate their assumptions, test those assumptions, hold themselves accountable to the empirical answers as they reveal themselves, and immediately and decisively change their approach based on the new information. The best entrepreneurial teams “brutally interrogate reality” more quickly than competitors with regard to their financial assumptions and projections. In short, they move more rapidly through OODA decision-making loops. By analyzing a startup’s financial assumptions and projections, what I am really evaluating is the intellectual honesty, customer-centric mindset coherence, and OODA loop speed of the entrepreneurial team. In this way, my financial analysis is really just another way of taking measure of the team.
I hope this provides some helpful and useful perspective on how I evaluate startups. In the future I will try to dive more deeply into each of the topics discussed above. In the meantime, on a tactical level, I’ll end with one simple observation about the typical entrepreneurial presentation:
If you wanted to construct a presentation flow that was more perfectly the inverse of what I actually care about and evaluate, it would be hard to do. Instead, please consider the following approach:
In short, tell me a story. Tell me who the protagonists and other characters are in the story. Tell me what goal or milestone those characters are trying to achieve, and how valuable that goal or milestone will be if/when it is reached. Tell me what challenges the characters will face along the journey, and how the characters are likely to respond to those challenges. End by telling me what role you’d like me to play in the story, make sure I want to play that role, and nail down the process we will mutually go through to see if that role is a good fit for both of us.
As Jim Collins has so concisely said, “First Who, Then What.” It’s good advice for entrepreneurial evaluation, for investor presentations, and for life.