I once showed a company to an investor for an investment we were syndicating. This investor loved the team and thought the solution they were building was compelling. Ultimately, this firm passed because they couldn’t get comfortable with the “market size” given that they were a big fund and only targeted $1B+ opportunities.
Similarly, I remember years ago when I was looking at the series A investment in a company called Lumos Labs. The company is the leader in online brain fitness games and has over 14M members. But these were the early days of the company. I loved the founder, but was struggling because this just didn’t seem “big enough” to me. I remember talking to one of the angel investors (and also one of my old mentors) about what the company could become, and what it would look like if it ever became a really big business. I wondered if it could potentially be a “platform” for something else (the most meaningless and overused phrase that entrepreneurs and investors try to use to make companies seem more important than they are).
His answer was so simple, and at the time, I kind of dismissed it as the view of an angel investor who didn’t really “think like a VC”. After thinking for a few seconds, he just said: “I just think they can get big by selling lots and lots of games”.
VC’s pass because of “Market Size” all the time. It’s maddening feedback for entrepreneurs, because no one likes to think they are not working on a “big enough” opportunity. Sometimes, it’s true – the market really isn’t big enough. But often, it’s either not really the case, or truly impossible to tell. How does one measure the market size of a company creating a completely new market, or one that is trying to unlock non-consumption vs. stealing share from existing players?
The problem with the market size feedback is that entrepreneurs end up being stuck. How do I change the size of the market I’m going after? It’s very discouraging. But the reality often is that investors don’t pass because of market size. They pass because of doubts about customer adoption. It’s not a question of “are there a lot of potential customers for this”, it’s more a question of “I don’t really believe that lots and lots of customers will buy/adopt this”. The early traction may be interesting, but the investors fear that demand is driven by a relatively small niche with idiosyncratic tastes or needs.
The investors just don’t believe that you can simply sell lots and lots of games.
If this is the case, then there is actually hope! It’s actually possible to change an investors mind about customer adoption. And if you can do that, you can probably tell some story about how the company can indeed accomplish more than anyone today thinks is possible. The game plan then is to show accelerating user growth, across a variety of user segments, and understandable and declining acquisition costs. At some point, investors may start to change their mind about the market size.
Parting thought #1 – funny enough – in the first example above, the investor actually asked to be kept in the loop for the next round of financing. Puzzling, seeing as the market size was not going to mysteriously change.
Parting thought #2 – there is at least one company I know today that is reported to be raising a very nice round at a good valuation from terrific investors. Earlier on, many many investors passed, and I think largely because the company didn’t seem to be going after a big opportunity. But they kept plugging away, growing users aggressively to the point that the opportunity they are going after did look pretty big after all.
Go figure.
There was a lot of chatter last week about the “Series A Crunch”. It started with this post and has stirred a bunch of commentary. The gist of the story is that there has been a significant increase in seed stage investments activity over the last 2 years, and many companies are now coming back into to the market for their next round of financing. The problem is that the availability of series A dollars has not expanded – in fact, it has contracted. As a result, there is going to be a bloodbath of dead companies in the next 6-12 months.
Like most things in the tech blogosphere, reports of this crunch are somewhat exaggerated. I think it is indeed true that there have been more seed stage companies funded in the last couple years, and that will lead to a relatively more crowded series A fundraising market right now. But the repercussions of this are not as dramatic as some people are reporting, and for most investors, it’s going to be business as usual. Here are a couple sub-points to hopefully bring a bit of sense to this discussion.
First: This is nothing extraordinary and comes to no surprise. Investors who have been in the early-stage investing game for some time know that markets come and go. Sectors get hot one day, and less interesting the next. Smart investors don’t try to time the market. Instead, they try to maintain a steady investment pace, and create diversity across time (a form of diversity which is often overlooked). Although the next few quarters may be somewhat more challenging for seed stage companies to raise their next round, it probably means that it’s a great time to be making new seed investments as other investors are distracted tending to their portfolios.
Active seed investors have also known that this was going to be coming. We’ve seen valuations creep up as more capital has entered the seed stage (although this have varied quite a bit by geography). I’ve been telling our portfolio company founders about this for half a year, and if you watch carefully, many of the most successful institutional seed investors like Floodgate or Harrison Metal have actually slowed their pace a bit the last few quarters because of all the new capital that has entered the scene. Instead, we have picked our spots, been valuation disciplined, and tried to put our portfolio companies in the best position to stand out when they do go out for more money. Balance will be restored, and it happens surprisingly quickly. The investors that have a strategy and stick with it will be rewarded over time.
Second: repurcussions of this series A crunch is overblown and net-net will probably be good for the startup ecosystem. I really don’t think it’s going to be bloodbath some people think it will be. The main reason is that many of these companies that have been funded were never really candidates for investment from large VC’s anyway. Broadly, I think there are two kinds of companies that fit the bill.
- Companies that are capital efficient and can get to viability and a very interesting returns without VC funding. Taking VC money is not the ideal path for every company, and the capital efficiency of internet businesses means that more and more companies can actually yield a successful outcome without taking large amounts of capital from very large funds. So these companies aren’t really effected by the crunch since they weren’t part of the VC funding chain anyway.
- Companies that want to raise VC money, but probably never had a chance to begin with because they weren’t going after big enough opportunities. VC’s have very strict incentives when they invest in companies. Because of their fund size and the return profile of VC portfolios, VC’s only invest in companies that have the potential to be very very big. That’s why the #2 reason why VC’s pass is because an opportunity is not “big enough”. Investors that work with VC’s often understand this, and it will usually factor into how they think of their portfolio composition. Angels that have just been dabbling in internet investing will be hurt here because they may have invested in companies going after opportunities that likely would never be perceived as big enough to get large VC’s excited. Institutional seed investors may have a handful of these too, but it usually is a minority of their portfolios and they have mentally expected to push these companies to get to CFBE quickly or find other non-traditional funding sources to keep these companies going.
I think a lot of the surge in new companies can be attributed to these two categories. I do think that there are also companies going after VC-scale opportunities and are performing “ok, not great” and are going to have a disproportionately harder time raising their next round. That is probably true, but there will likely still be some name-brand companies that come out of this crop. It will just take a bit more time for these companies to stand out.
Onwards!
It’s been a few weeks on my first post on “Distruption“, so I thought it was time to do my second installment of the Startup Jargon Series.
This time, I’m going to discuss the concept of the PIVOT.
I had a maddening conversation with an entrepreneur a few weeks back. You could tell that this entrepreneur had done a little too much reading of pop tech blogs and not enough real reflection on some of the underlying concepts. This entrepreneur was telling me about the team’s early experimentation and described (I kid you not) 4 different pivots they had done.
The problem is that those “pivots” weren’t pivots. For basketball fans out there, a pivot usually means that one foot remains planted (the pivot foot) and the other foot goes somewhere new. This entrepreneur wasn’t describing pivots, she was describing travelling violations. They were completely different products going after completely different customers.
Pivots are very common for startups – almost all companies make several pivots in the course of their existence. But what I think the pop tech community considers high-profile pivots are sometimes not pivots at all. The concept of the pivot has obviously been around for a long time, but more recently entered startup jargon with the rise of the Lean Startup Methodology. The pivot is intimately tied to the core concept of the lean startup: that the goal of a startup is to search for a repeatable and scaleable business model. That search is focused on maximizing learning, through a rapid progression through some sort of customer development process. As a result, pivots occur when a change of direction occurs but grounded in previously validated learnings. Something new is pursued, but leveraging something old or learned. Specifically, there are typically three types of pivots:
Customer Segment Pivot: This occurs when prior learning suggests that the same product may resonate with a different type of customer. Usually, that is a customer who is facing a similar problem to the one the startup was trying to solve originally. So, SAME PRODUCT, DIFFERENT customers. My favorite example of this is the transition from thePoint to Groupon. thePoint was a platform to motivate collective action. There was a way to establish a tipping point for support of a cause. It was targeted at fundraising needs of organizations. But in talking to small businesses, Andrew realized that it was actually an excellent mechanism for small businesses to drive massive amounts of interest in a short term deal. Same product, similar need, different customers.
Customer Problem Pivot: This happens when prior learnings help you appreciate a deeper or different problem that your customers face that you are able to solve. Often, it’s not until you get deeply engaged with your customers that you really understand their needs. And sometimes, the realization is that the product you have been building can never satisfy their needs, but something else might. These kinds of pivots are why I have claimed that fast followers are actually leaders in disguise. Often, fast followers look like copycats, but actually have been engaged with their customers for a long time before doing a pivot. Sure, the inspiration for the new product may come from another company, but the opportunity is identified and executed on very quickly because of existing knowledge about the customer and their problems. This is why RueLaLa was in a great position to claim the #2 spot in the private sale space given their experience with fashion brands that were trying to liquidate their inventory through Smart Bargains.
Feature Pivot: This occurs when prior learnings show that one particular feature of the product is resonating with customers, and the company shifts its focus to orient around that feature. Paypal is the classic example of this. I’m not as close to the story of Instagram via BRBN, but I understand it was a pivot that also fits into this category. The key lesson from these pivots is to focus on the data. How are users using your product? Instead of just worrying about why they aren’t using it the way you intended, try to figure out why they are using it at all, and whether that is evidence of something really valuable about what you have built.
So, that’s a drive by shooting overview of Pivots. I won’t expand more except point you to the work of Eric Reis and Steve Blank who have much better things to say about the topic than I do. Let me just close with two observations about where I think people have gotten lazy about the concept of Pivots.
First, pivots are not restarts, and there is nothing wrong with a restart. Pivots can be a good thing – they are derived from data and customer learnings. But they assume that something you are doing is right and worth pivoting on. But sometimes, that doesn’t happen. It’s a hard pill to swallow, but that’s ok. You’d rather figure that out quickly and move on, rather than fight a battle that can’t be won. I was really impressed the first time Paul Graham did “office hours” on stage at TC Distrupt and he encouraged the entrepreneur that was pitching him to “start over”.
There is nothing wrong with starting over. Some of the best companies were born out of restarts. Twitter and Turntable.fm are recent examples. Maybe the founders of those companies did draw on some learnings from Odeo and Stickybits, but the services are completely different.
Second, pivots in the context of a lean startup isn’t only about getting to product market fit. It’s not like once a company has successfully built a free service with traction that pivoting or customer development is done. The goal of any business is to create a sustainable and repeatable business model. This means more cycles of testing, iteration, and potential pivots. Twitter is a big company with lots of user traction, but I think we continue to see many pivots from the company as they search for a repeatable business.
I watched Moneyball last night. Fun movie, but as is usually the case, the book was better.
I did enjoy watching their depiction of the old school scouts talking about the different players they were evaluating. Hilarious stuff:
“A guy with an {unattractive} girlfriend has no confidence”
“You’re gonna be a superstar because you’ve got a great face”
Sounds absurd, I know. But is it really that different compared to what happens every day when interviews are conducted or even when VC’s evaluate entrepreneurs?
We end up making snap judgements about people and decide in a 30 minute conversation or presentation that “I like that guy!”. We sometimes spend a bunch of unstructured time with people “getting to know them” over meals or drinks. We think that if we just are in the presence a bit more in more casual settings, we can either get them to say something revealing or we just get a better feel of what it’s like to be around them.
It’s amazing how much people evaluation is driven by gut. And to some extent, it has to be. But I think that leads to some laziness about evaluating what almost everyone says is the most important factor of any business.
Another problem with going with your gut is that we are prone to confirmation bias. When things line up with your expectations, you are quick to mentally score one in the “win” column and say to ourselves “yep, I knew that person was a winner immediately.” When things go wrong, it’s easy to think “yep, I was always worried about X or Y with that person.” But the reality is that you probably had things you liked and didn’t like, but emphasize the ones that correlate with the outcome when you reflect in retrospect. This leads to more confirmatory “data” in our heads, which only give us more confidence in using out gut in future personnel decisions.
Does this sound familiar? I think if we are honest, it probably does for many people. I’m definitely still in the early part of my learning curve on this. But there are a couple principles that I’ve picked up from things I’ve read and tried that I think could be helpful. A lot of these principles are drawn from the academic research of Geoff Smart who actually wrote a paper on “Management Assessment Methods in Venture Capital”. In a Moneyball-esque approach, Geoff actually looked at the evaluation methods of VC’s in selecting entrepreneurs, and tried to tie that back to the ultimate outcomes of the companies.
- Know What You Are Looking For. Seriously, just take 10 minutes and write this down before you start your process. This sounds simple. If you were going to buy a house, you might take a step back and think about what attributes you are looking for, what characteristics are important to you, and then evaluate potential purchases against those factors. But with people, that rarely happens. Sometimes, there is a job description of some sort written with a “qualifications” section, but most of them end up being super generic with qualities like “self starter”, “highly motivated”, “collaborative”, or other random stuff that you hope every employee has. Instead, think about the 2-3 qualities that really really matter – the qualities where you’d sacrifice deficiencies in other areas to get someone really exceptional. And remember that these qualities change for specific roles, specific types of businesses, or even for the same business but in different times or contexts.
- Drill down on the stuff you care about. Once you know what you are looking for, be tenacious about drilling down into those qualities. Go deep. Control the interview, don’t let it be a meandering chat. If you really are looking for someone who is exceptional at X, don’t be satisfied with a bullet on the resume that says they can do X. Don’t be satisfied with one nice story about doing X well. Get 3, 4, 5, or more specific examples about these qualities. Write them down so that you can follow up later.
- Be Maniacal About References. This goes without saying, but happens shockingly less frequently than it should. Again, we often have so much confidence in our judgement of people that we end up looking for references that are likely to be easy, do one or two, then call it a day. My partner David wrote a good post on due diligence calls, so I won’t belabor the point here. What I’d add is that the better that you’ve done #1 and #2, the more value you can get your of your reference calls and the easier you can figure out if the other person is BS-ing you. That’s why it pays to go deep and to be diligent about keeping track of details. Do you really want someone who tells you about heroic accomplishments in “running” a project when their boss later tells you that they were just executing on a straightforward playbook within the company? Oh, final point – being maniacal actually doesn’t mean that you are looking for perfection. Good people sometimes rub others the wrong way. But if you really know what you are looking for, you can more easily make sense of bad feedback and balance that against the positives.
- Move Fast. Both in hiring and in firing. Seriously – more coffee meetings or drinks at the bar isn’t going to change things very much. And in a ridiculously competitive environment for talent, agility is a great asset and differentiator. I really believe that you can do effective hiring and people evaluation if you focus and just do the work. No need to drag things along. Same thing with firing too. It needs to happen quickly and decisively. I was extremely impressed with a first-time CEO of a portfolio company a few weeks back when he reported to his investors that he had let go of a key contributor to the team. The team is super small, so every lost person is a big deal, and this person had a great background on paper. But the CEO knew that he wasn’t working, and let him go. No long deliberations with the board or advisors. Maybe a little with other team members, but it was swift and decisive and professional.
For further reading – check out Geoff Smart’s book and also this great blog post by Paul English at Kayak.
I’m going to do a new blog series on “Startup Jargon”. There are some words that I hear all the time as a VC – both spoken by fellow investors and by entrepreneurs. They are said so often that they have almost lost their meaning, and I find that unfortunate since many of these words reflect very insightful and important concepts. It’s too bad that they get bastardized and used loosely and inappropriately.
So, I thought I’d do a little cliff-notes summary of some of these terms. I’m not claiming any original IP, but hopefully will be able to pull together some good thinking on these subjects and add some precision to these words. Some of the concepts/phrases I’ll cover are:
- Disruptions
- Pivot
- Viral
- We’re not raising money…
I hope to add a few more as things progress, so please share your suggestions!
So, the first topic I want to bring up is “Disruption”
You hear people say “This is truly disruptive!”, “I’m looking for disruptive companies”, “We want to disrupt this market”, etc.
Aside from the actual definition of “Disruption” the word received a turbo-shot of in-vogue-ness as the work of Clay Christensen became popularized. His seminal work, “The Innovators Dilemma”, talks about the concept of disruptive innovation. Christensen defines disruptive innovation as:
“A process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves ‘up market’, eventually displacing established competitors.”
The underlying concept is that most industry incumbents are successful at delivering “Sustaining Innovations.” These are like product improvements that satisfy existing groups of customers and improve against vectors that a company’s biggest customers care about the most.
The idea behind a disruptive innovation is that there are a whole host of other potential customers that might care about completely different attributes of a product or service. The incumbents have a hard time addressing these customers because
- It’s perceived to be a trivial problem
- The target customer group seems too small
- Delivering against those attributes would mean failing to deliver against other attributes that their big customers care about
- Delivering against those attributes means a service with lower margin, thus, the effort never gets approved
Not all innovations are “disruptive innovations” by this definition. “Disruptive Innovation” is not a catch-all for any innovative proposition that seems big and different. Instead, it’s talking about a very specific kind of innovation that is made possible by very specific market dynamics.
How Does One Know If Something is Really Disruptive?
Based on Christensen’s work, there are certain things that you almost always see in disruptive innovations. These are two questions that I’m asking myself when I hear the word “Disruption”.
Question #1: Are you going after non-consumers or low-end customers?
In disruptive innovations, the target customers are either non-consumers of existing alternatives or the unattractive customers of the incumbents. You sometimes hear the phrase “low-end disruption” because the innovative company looks like a low-end product and targets the unattractive users of the bigger companies. Let’s take the blogging CMS world for example. WordPress is arguably the incumbent in this space. They focus on tools that large scale publishers and/or bloggers use. Tumblr, on the other hand, initially focused on the many casual bloggers that wanted to get started in blogging, but quickly abandoned their wordpress or Typepad blogs because it seemed to be too cumbersome of a task. In a way, Tumblr was focused on WordPress’ low-end customers.
Questions #2: What attribute of competition are you going to excel at that others don’t care about?
Disruptive companies are explicitly striving for differentiation across a different plane of competition than the incumbents. You can think of a company as trying to deliver excellence across some attributes and not others. You can’t be good at everything after all. If you were to plot “Level of Excellence” on a Y axis and “Attributes” on the X axis in order of importance to the incumbent, you would get something like this.
Now, the disruptive company comes along and decides “you know, I think there is a whole class of customers who only need a so-so level of attribute 1 and 2, but really really care about attribute 5. In fact, being good at attribute 5 probably makes it really hard to be good at attribute 1, which is why the leader in the space doesn’t focus on it.” So their graph looks something like this.
Let’s take WordPress again – while the company was trying to satisfy its larger, professional publishers by offering the most robust CMS with the most flexible features and most developer friendly tools, Tumblr came along and offered a very limited feature set that was clearly insufficient for many of WordPress’ best customers. But they did deliver on excellent usability and design and a social reading experience through the dashboard so that even infrequent writers could get value from their service.
Parting Thoughts
- Just because you are going after a non-consumer or low-end customer doesn’t mean that you will be disruptive in a meaningful way. You actually do need to be right that a large market will be unlocked that care enough about the attribute of differentiation you are targeting to adopt your product en-masse and actually pay enough to build a real business.
- Notice that in the example above, I didn’t say that Tumblr excelled on simplicity. Simplicity is almost always an early trademark of the product of a disruptive company. But that is not usually the root of the disruption. Tumblr excelled at usability and aesthetics for casual bloggers, not on simplicity. Simplicity is usually a mark of all disruptive innovation, but those products usually do become more complicated and still remain disruptive. Put another way, disruptive products tend to be more simple initially, but simplicity does not make a product disruptive.
- Make sure you are really targeting an area of differentiation that the incumbents can’t or won’t really focus on. If you do, the existing players will typically win eventually. One example of this is on the attribute of “service”. Often, I’ll hear a startup say that they are going to win because of insanely great service. That’s a nice idea, but I’m sure that the CEO’s of your big competitors have also read Tony Hsieh’s book and probably are trying to figure out how to deliver great service, propped up by their better cost structure and margins. In some markets, this may be an avenue of sustainable differentiation (eg: airlines) but not in many, especially now that more and more companies are really focused on it.
- All existing companies go through the process of going from being the disruptor to being pulled towards sustaining innovations. So at some point, your disruptive company will in turn be disrupted by someone else. Just as the incumbents struggled to keep pace with new entrants or dismissed them entirely, don’t think you are immune to this jus t because you are a startup. As Ferris Bueller said: “Life moves pretty fast. If you don’t stop and look around once in a while, you could miss it.”
- For more on innovative disruption, check out:
robgo:
leehower:
davidbeisel:
