Back Testing Why Entrepreneurs Received Early “No Interest” from New World Angels
Demystifying why promising and even profitable businesses are not always investable.
By Ron Tarro, President, New World Angels
You can be a profitable business. But you may or may not be an investable business. This is an important starting point for understanding early stage investors and their investment decisions. So why would you not be sufficiently investable? I walked through the last year of Florida company submissions and categorized (unscientifically) why we did not move toward funding these companies. Indeed, as chair of investment screening, I keep notes on every company that submits to New World Angels (this behavior is enabled by a personal addiction to the Evernote App).
First, a quick nod to the New World Angels screening team. They are a sub-group of about a dozen+ NWA members. They invest serious energy into reviewing your company. They share an interest in entrepreneurs like you, and they were often once, like you, a founder and entrepreneur. New World Angels cannot fund everybody. But if we can help you design a better business strategy and investment pitch, then we all win (and the world also wins). These comments are provided in that spirit. We maintain deep respect for people attempting to create the future.
Before I start: let’s not get too dogmatic. There are exceptions and nuance to every one of these points. And if you surf the web you will find repeated variations to every point I make here. So treat these as principles and as a basis for reflection on how you have designed your business, and as to how New World Angels, just one of many funding sources, might evaluate your investment opportunity.
Here are the principles. They are in no particular order.
NOT BETTER ENOUGH. It’s possible to create something that is “better” yet not “better enough”. What do I mean? Think about your own life (or your professional life). There may be a better online banking solution out there. But there’s a switching cost to changing banks. This is even more formalized with business and professional products. My walk through our funding requests show a large number of companies with an interesting “twist” to existing categories of products. But their products and services are of only marginally higher value than competitors and the incumbents. Early stage investors will ultimately choose measurably disruptive leaps in customer value over incremental changes. Here’s your takeaway: Maximize your product value from the status quo. By the way, here’s one of my methods to figure out if your customer value and motivation is merely incremental: I listen to whether you pitch low price (not high value) as your market advantage. Foundational cost advantage is possible if you have a new and disruptive next generation technology. However, if you are cutting price without this transformation, you are really addressing low customer motivation and minimal differentiation from the status quo. This is not a good place from which to start your company and a tough sell to investors.
NO BLUE OCEAN. You're in a small boat in big waves with limited gas. There’s a book out there called “Blue Ocean Strategy”. It’s long been mandatory reading for business strategy nerds (like me). I’ll save you some reading time. Here’s what you need to know when applying the book's lessons to early stage capital fundraising: the most interesting companies for investors are ones that are creating or are capturing uncontested market space (blue ocean!). They have products to which there is no direct alternative. Or they are filling a real need that nobody realized existed. This is not a claim that solutions in a competitive market are un-fundable. But it is a suggestion that your investors may choose new wide open "blue ocean” opportunities before they choose founders seeking to sail in the shipping lanes. I’m mindful that Elon Musk with both Tesla and SpaceX can be used as a counter to this argument. I would just respond, "OK then, convince your investors that you’re Elon Musk.” Here’s your takeaway: think carefully about your choice of, and positioning within, a marketplace. Have an argument about your long term defensibility against market entrants and incumbents.
LIMITED MARKET SIZE. A business that serves Miami Dade County is harder to venture finance than a business that serves an entire country, if not a world. Market size limitations naturally limit the value of the company. Understand this important point: an angel investor makes money on the difference between the value of the company at first investment and the value of the company when it is sold. A small addressable market for products points to a small “exit” for the investor. There are always more startups than money to invest. So your angel investor will pick the company with the larger potential market as measured in potential revenue. Notice that I said “revenue” not “number of potential customers”. Here’s your takeaway: define your serviceable market(s) broadly, in revenue terms, and be able to defend it.
BAD GROWTH MATH. What if it costs you more to get a customer than what you can extract in lifetime revenue from a customer? What if the prices you are charging are not sustainable in the next five years? We think about these things. You should too. Our due diligence wonders if your revenue can outrun your costs. To illustrate, have you noticed that angel investors might fund a next generation of accounting software, but they won’t fund a CPA firm? It’s true. Here’s why. The CPA firm’s margins don’t support investable growth because the CPA firm's costs closely follow revenue growth. They must hire more accountants to support their growth in clients! Contrast this to a SaaS accounting software company. People are buying and using that SaaS software while the SaaS team is asleep in their beds. Revenue can outrun costs. Businesses where revenue is built upon hours worked are less attractive than businesses where the incremental cost starts low and even falls for each additional sale of the product. Growth math starts with your investor understanding the growth margin for your product. Growth margin roughly speaking is your customer lifetime revenue over some period of time (minimum one year) minus your customer acquisition costs (sales and marketing), and then minus the material cost to create, deliver, and support the product over that period. Notice that I did not include your R&D and administrative costs (at least for now). Low product margins will naturally require more investment capital. This unto itself is not an issue. But we will worry that your capital requirements could outrun your growth in value. This dilutes an early investor’s position in your company. The takeaway: you benefit by designing a product or service with a naturally high and naturally improving profit margin. The insightful word in that sentence is “design”. It’s also wise to define your your product margins explicitly for investors, lest your investors decline or offer funding using a misunderstand (or miscalculated) financial assumption.
UNDER-BUILT TEAM. You the founder have simply “under built” your team. And I do mean “team”. Our impression of you as CEO or leader will influence our investment decisions. But a single founder can fall out of a boat and get eaten by sharks or alligators, suddenly putting the investment in crisis. Further, there’s the question of domain knowledge and experience. Are you all knowing and omni-present? Can a news anchor build the world’s next generation of encryption technology? Maybe; innovation can come from interesting places. But since we’re betting money (and we would be), we would be looking at the team around the news anchor for evidence of encryption experiences. Takeaway for a founder: build a compelling core and advisory team directly related to both your products and markets. Do this before you seek funding.
ZOMBIE RISK. Here’s some news. Most angel invested startup companies don’t fail. Instead they linger. Zombies are profitable companies to which our investment is trapped. The company and founders are doing fine by the way! They are competent and the company is maybe growing a little. But there’s no way to get investment money out. Traditional investors rarely want a share of your quarterly profits in perpetuity. They can achieve that at lower risk and with better liquidity by owning publicly traded dividend stocks in their IRA. Your investors focus is achieving a long-term capital gain. They want to give you a chunk of money. Then they want, for the risk taken, a multiple of that money back in a few years. This allows them to place the next investment with the next entrepreneur. Angel investors are more patient than institutional investors in this regard. However, it’s still a fundamental question: will my money get trapped by a competent and comfortable founder with low motivation for investor exit? The takeaway: if you are seeking money from investors, you must describe how investors can recover their investment. More plainly: who could possibly buy your company someday and why?
VALUATION REALITY. Your company’s valuation will quickly drop you out of investment consideration if not rationally supportable. Remember that early stage investors make money on the difference between your company’s value today and its value when the angel investor exits the investment. Let’s do some math. Let’s suppose an investor’s goal is to make 10 times their money over five years (this is a fairly typical conceptual goal as the investor's winners need to fund their losers). You tell the angel investor that your company is worth $5MM. The angel investor thinks, "OK, we need to add $45MM in value for this company to reach my 10x goal … I wonder if that’s possible.” (I’m ignoring some complexities like dilution). If you’ve somehow not illuminated the road to that valuation then your investor starts to worry. They begin looking much more carefully at you, the team, the size of your market, the competition, your product readiness, customers if any, and profit margins. Your valuation is in the end a negotiation driven by investor confidence in your attaining the $45MM. If you can’t explain how to get there? Valuation math is less impactful when investing in valuations below $5MM because we understand the company is young and there’s more uncertainty. Valuation math over $5MM and especially over $10MM require increasing confidence in your growth strategy.
SMALL MONEY. SMALL FUTURE? We love founders who are capital efficient. They don’t overspend and don’t over-raise in financing. But it’s possible that you did not ask for enough money; therefore we passed on your company, and you are surprised. Yes, our decision may seem counterintuitive. But here’s the argument for such a decision. Angel investors want you to succeed. But they have learned from experience that founders succeed by achieving important milestones that increase the momentum (and valuation) of a company. Founders who are raising money in dribs and drabs, month over month, are caught in some form of “flow” which cannot be evaluated by investors as business progress. So when you show up asking for $50K we ask: “how long will it take you to spend $50K and what will you have accomplished”. We’ll also ask: “what happens after the $50K is spent". If your answers include things like (respectively) “the money will keep the team on track” or “getting the next round of investors" then we’ll say “come back when you have a solid argument on how you will use maybe $500K.” Here’s your takeaway: describe to angel investors how you will use a substantial block of investment defined by a series of milestones over maybe 12-18 months. If necessary, investors can break that larger number into a series of smaller investments (tranches) based on your progress. By the way, there’s a hidden subtlety in this conversation. Small requests imply low expectations for company growth and or its prospects. With lower access to resources, your products develop more slowly and company growth is likely slower. That may preserve your founder's equity but that slowness is a risk for an investor. Is somebody running faster than you?
TOO EARLY. New World likes a foundation upon which to finance a company. This foundation could be a minimum viable product or maybe a prototype. It could be foundational research upon which to build the product. The foundation could be meaningful milestones like early customer revenue. It could be a customer or strategic relationship that will float you into the market. New World Angels tends to not invest in unexecuted grand visions. Our investment focus is statistically skewed to companies with demonstrated investment in their products. Give us a vision and a solid foundation.
SELLING NOT EDUCATING. This is personal and professional. New World Angels are idealistic in wanting to see you succeed. But they are also successful people who question most things told to them. “Only the Paranoid Survive” said Andy Grove of Intel. So here’s a story to illustrate a problem. A founder is pitching their product to our New World Screening team. The founder claims: “We are the first company to _______ “. A screening team member hears that claim and while listening begins searching DuckDuckGo (a shameless plug for my favorite search engine). Your presentation ends and our private screening team discussion ensues with this first comment: “I found another product just like theirs; whaddup with that?”. You won’t get funded. You are now caught in one of several unhelpful scenarios. Scenario A: you really didn’t know about that other company so you are blind to your own market space; or Scenario B: you knew and decided not to tell us, or Scenario C: it’s not really a competitor and we are mistaken, but you did not differentiate yourself sufficiently. Here’s a second investor presentation behavior that can diminish your position: “we are really excited about our industry leading _______”. Let’s decompose that statement. First, from an investor perspective your excited emotional state is not a motivation for investment. But you have also trotted out an amorphous thing called “industry leading”. These statements are collectively evidence that you are “selling" to your investors. However. We are going to invest in your company having thought analytically about your business and its environment. Here’s your founder takeaway: Do not “sell" to experienced professionals, and especially to professional investors. Educate them. Share analysis and reasoning. Every glowing superlative in your presentation deck diminishes your investment prospects. Every clear defensible analytical insight raises your prospects. Best possible reaction from an investor: “Wow this person has a clear analytical mind and has deep insight into this business”.
So what to do with these principles? Develop your customers first and foremost. Design your business for maximum customer impact. Their revenue is your cheapest source of capital. Then “back test” your business strategy for investors using the above principles. Said differently, you are not in the business of raising venture capital. You are in the business of serving customers. Investible or not, best wishes and thank you for seeking to improve our world through your products and services.
We’ll try to update our (ever changing) perspectives on investment decisions through this New World Angels blog. Subscribe to the blog here: https://www.newworldangels.com/blog