Contributed by Merle Sprinzen Tessier, Managing Director of Golden Seeds
There’s no sure thing when it comes to investing. Daydreaming about a payoff can be fun but understanding risk is critical. You might wonder if an unfamiliar CEO is ethical. Perhaps you’re unsure the leadership team is the right fit. We could fill pages and pages with possible questions but answering all of those questions is not an efficient — and maybe not even effective — way to reduce investment risk. Instead, I think there’s a single, universal one to ask every entrepreneur before investing.
“What does the success of your company fundamentally depend upon?”
All startups are experiments. The founders are testing whether their hypothesis about a business idea is true, and if so, they (and you) can potentially achieve great success. The most important aspect of due diligence is to understand the key hypotheses a startup is testing, what has already been tested even somewhat, and whether the right plans are in place to test those hypotheses more rigorously — quickly.
This said, an entrepreneur must be able to clearly articulate what their success uniquely depends upon, not a generic set of factors. Of course, it’s likely that the key factors are in the “buckets” we all know: management team, product-market fit, market size, supply chain, business model, etc. But it’s on the unique set of two or three specific factors that the startup’s success depends.
No testing, no investing
What do I mean by a hypothesis?
Let’s take eBay as an example. I wasn’t involved in eBay when it started, so this is just a guess. But it seems to me that eBay’s success depended on sellers having access to the widest number of buyers possible and buyers having access to the widest range of sellers possible — the creation of a true free market. That would mean, then, that there could only be one true powerhouse in their category — they needed all buyers and sellers to come to their site — it was a “land grab.”
So, if I were betting on eBay in the beginning, I would have wanted to know how they intended to rapidly build that mass of buyers and sellers — their own success would block out competitors. I wouldn’t have cared about initial profitability. Achieving that mammoth scale rapidly was what was required for success, and if a competitor got there first, eBay would have lost.
Then there’s Starbucks. Again, there’s a lot behind their success, but I’d guess a key early hypothesis was their belief that people would pay around $5 for higher quality coffee and a better in store experience. If the top price for their cup of coffee was set at $2, letting customers hang around wasn’t going to work for their proposed scale; there would have been no need to invest in ambiance and build a brand reputation.
For “Starbucks the startup,” you would have wanted to know how they were testing people’s willingness to pay a lot more for what typically had been a cheap “get it and go” experience. You might also have asked about their marketing strategy, specifically, how they planned on educating consumers on quality and introducing a new coffeehouse culture to the United States.
In both the eBay and Starbucks examples, the hypotheses were gutsy. One entailed a winner-take-all sprint to market, the other challenged long-held consumer behaviors. They paid off, but undoubtedly, to get the capital they needed, they had to prove they were on to something.
Closer to home
This process — identifying hypotheses, requiring answers — happens every day at Golden Seeds. Here are a few examples of different types of startups we’ve supported and the hypotheses they are testing.
Little Passports is a consumer subscription service that “delivers the world” to children ages three to 12 each month with fun activities and online games. Its founders felt it was important to inspire children to learn about the world around them and other cultures from an early age. They also knew that children are not learning about geography at school.
They believed that in our increasingly global society, parents would pay for their children to begin acquiring a global focus early on. It meant identifying targeted parents/grandparents and convincing them to purchase in a cost-effective way. They spent their time testing messages and marketing channels. Of course, their product had to delight the children, but that delight alone would not bring business success. They had to be able to convince parents to purchase, and as the company enters its 10th year, it’s clear they’ve figured that out.
Work Truck Solutions is a business to business (B2B) play. They provide an online solution to help dealerships sell more commercial vehicles and save time doing it. The idea arose when its founder tried to help a colleague who owned a car dealership find a plumbing truck for a customer. She quickly discovered that it wasn’t easy to search for such trucks online.
The hypothesis was fairly straightforward — commercial salespeople would pay for a faster way to sell more trucks. By making the information about commercial trucks easily accessible for the first time, their clients have a demonstrable ROI for turning web visitors into customers.
And as a third example, there’s nVision Medical, a life science company that provides early detection of ovarian cancer. Like all companies, but perhaps more obviously for life science companies, the product needs to actually deliver the health benefits it claims — a key hypothesis. A second hypothesis, given the nVision Medical business model, was could it attract a large company with the resources to get it to market quickly and therefore not have to raise the commercialization funds itself?
The nVision Medical solution was promising enough to attract a $275-million exit to Boston Scientific. This allowed the company to return more than 10x to investors on a pre-commercial product in just five years.
The golden rule
“What does the success of your company fundamentally depend upon?”
I meet with many entrepreneurs and they would be well served in making this the primary point of discussion. Once I understand what problem they’re trying to solve (when I’m still not entirely sure by the end of their presentation, that’s another warning sign), I then want to know the very few factors on which their success depends, and how they have and are going to test those.
Asking this question is my “golden rule” for angel investors. Entrepreneurs should be able to answer it articulately. It’s how I can tell whether the entrepreneur has thought deeply about their business and how you can evaluate if they’re on the right track.
For all involved, it decreases risk and increases the likelihood of success.