April 2009

Dennis Lankes of startupslive.tv commented on my recent post, asking me this:

You work with startups and talk to investors all the time. What is it that really catches people’s eye and attention at a pitch? What are the questions the investors want to hear answered? Can you help me out?

Sure.

That seems like a reasonable question. What’s really fun is to start by thinking about what you’d want, if you were to invest money in a startup. You’d want a big payoff later for money invested now. You’d want as little risk as possible, in a very risky business, for as high a payoff as possible.  Right?

Yeah, for sure, but how do you get there? That’s the end point. So here’s a list:

1. Potential growth.

Usually that means products rather than services. You can sell more products by making more and ramping up–which we like to call scalability. It’s about leverage. If you sell boxes, not hours, you can sell more boxes without having to bring on proportionately more people. The investor makes money when the successful startup goes liquid. Liquidity comes from either IPO–not likely these days–or getting acquired by some other company. That doesn’t happen without growth.

Services, in general, are harder to grow than products because there’s not as much leverage. But that’s not true for all services. Web services, for example, can be very attractive to investors. As a quick test of whether a service might be interesting, ask yourself how many people you have to add to double the volume. With a lot of services–say business plan writing, for example, or graphic artistry or limo services, you have to double the people to double the volume. Investors call that a “body shop,” and they don’t like it as much.

Another major concept that’s wrapped into potential growth is the product/market fit. I like this phrase, which I saw first in a post by Marc Andreessen, “The Only Thing That Matters”, because it absorbs both benefits and market size. You don’t separate those two concepts.

This basic concept flows into many facets, such as positioning, defensibility, potential market, proprietary technology–all those factors that generate potential growth.

2. Potential Payoff in 3 to 5 Years

They call that an exit. It means a way out. And just like prisons, investments without any way out are very confining. Investors want an exit strategy.

Entrepreneurs take note: Investors don’t want to hold a share in your happy and healthy company that lasts forever and never creates liquidity. How would you like to put money into somebody else’s company and never see it produce any money for you? That’s why they call it investing.

If you have that dream about building your own company and turning it into a lifestyle business, then passing it on to your children, be aware that this scenario is an investor’s nightmare. You’re happy, so you don’t want to go liquid.

You can pretty much assume that a professional investor or sophisticated angel investor is looking to get at least $10 back for every dollar invested, and preferably $20, $50 or $100, and in three to five years’ time. Investing in startups is a risky endeavor.

As an aside, I’m amazed at how often entrepreneurs take this as some sort of character flaw on the part of the investors. Why do they want so much return? What’s wrong with them? The reason is that they know that startups are very risky. Lots of them fail. So investors want to hit big with the winners to pay for all the losers.

3. Reassurance on Risk

Investors know this is risky business. Nobody’s pretending you can produce a new business without risk. There are, however, factors that reduce the risk, keep it at a minimum level. For example:

• A good team: Founders they can believe in. People who know the industry, people with product development and market expertise. The best proof of intellectual property, better even than patents, is credible founders.
• Startup experience: Sorry, I know this is tough for first-time startup people, but having been through the process at least once before makes people on the management team much more credible.
• Defensibility: Might be patents, might be know-how, might be first-mover advantage, proprietary technology or maybe something else. Investors don’t want to see a good idea that serves the world only to point competitors in that direction.

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