Startups and angels: Along the way to success

"God is in the details." Mies van der Rohe

Whether you like the architecture of Mies van der Rohe or not, this particular comment does make you stop and think.

So often when people talk about businesses and startups, there is a great deal of high level talk about strategy, broad vision, and so forth.  When these things sound compelling, especially to the industry outsider, the business idea can be exciting.
In entrepreneurial businesses, especially new ventures, investors often focus on these broad, strategic themes.  They would like businesses solving “big hairy problems” of real value to the customer.  These are robust, growing markets.  Coupled with a proprietary advantage,  they often present compelling investment opportunities.

Years ago, a friend of mine was the founder of one of the geo-demographic data companies in the US.   These were the companies that began the whole consumer segmentation system based on census data and often combined with credit scores, etc.  (Remember consumer segments like “ranches and pickups?”) 

We used that information for a lot of our customers.  The joke around the office was always that the systems that performed the worst had the best customer service and the best performers provided customer service that was terrible.  I think we thought that the good product guys could get away with it because the detail of good customer service was unimportant with strong IP.

Of course, they were wrong.  People eventually gravitated to the less than good product because the company helped the customer use the data while the really good stuff got relegated only to the people who knew exactly what they wanted to do.  They got acquired by one of the other guys as I recall.

The detail got them.

In another example, I saw a catalog company the other day that had tried to smooth its cash flow by purchasing a week at a time.  In theory this kept inventory moving in regularly and spaced out payments to vendors. At the same time, the company would take advantage of specials and discounts within the range of the amount they allocated each week. 

The problem? 

The supply chain didn’t work.  It seems that the weekly budget would not allow the company to buy as much as it needed as quickly as it could be sold.  So, they were frequently out of stock on the fastest moving orders, usually at the end of the week.   (They would get behind on the fast moving items.  When they arrived a larger percentage would go to fill backorders.  Then their days out of stock would grow.)

By listening to orders come in on the phone,  it became apparent to the president that people were canceling whole orders rather than backordering.  Sales started to decline. 

They had insufficient command of the details to really understand what was happening until it had been going on for a long time.

In another company, the finance manger decided to cancel the software maintenance fee for the company management system since the company never called the help desk.  He saved $5,500.  What he didn’t investigate was that the software company uploaded new shipper pricing (FedEx and UPS and so forth) regularly.  That pricing drove the system that assigned a shipping cost to each order.  Net result at the end of the year – a $75,000 loss on under billed shipping.  Not much of an ROI on a $5500 savings. 

They had no command of the details of their actions.

A major manufacturer of X-Ray tubes once lost the secret formula for making the glass tubes.  How?  Retirement in the manufacturing area combined with turnover in purchasing.  Losses? Millions in premature failures under warranty.   They had insufficient command of the details required for success.

It seems to me that these examples may also point to an underlying attitude of insufficient respect for the concept of command of the details.   And yet, they are what make up the real value of the business – in the execution.

God is in the details.

We Only Need 1% of The Total Market!

Do I hate to hear those words. 

Nothing gives an investor the heebie-jeebies faster than that phrase. 

It means that the entrepreneur hasn't done the hard work of figuring out a business model at a detailed level, nor allocated the total investment required to achieve their goals.

They have looked at a total market and backed into a financial projection that looks great at a small market share.  In almost every context, to an investor it sounds like an excuse for a lack of detailed planning, based on the fact that the proposed venture is a "can't miss" sure thing, so why bother to really work the plan?

Yet, they have a very difficult time finding an example of a company that has 1% of the market in a stable, successful business. 

Why is that?  Markets are inherently unstable.  If the proposed business does start to grow rapidly, it won't stop at 1%.  And, if it achieves 1% and does stop, it won't stay at 1%.  It will decline.  If the end goal is to sell the company, who will buy it at 1% and declining?

If they achieve some early success, often at high profit margins, they will draw bigger competitors.  If they have protectable IP, their growth should accelerate.  Yet their plan is for a fast growth to a modest market share - almost surely not a combination that will work. 

Their planning process has not done the hard work of validating their assumptions - because just a modest market share" achieves spectacular results, they think.

What should the entrepreneur do?

Start with an exhaustive list of assumptions.  (Often people work these backwards.  They start with, say, a needed conversion to sales rate from a click stream and work back to the quantities and conversions at each step to achieve profitable results.) 

Once you have those, ask how each one can be validated.  Check the experience of others for detailed data.  If you don't already know about it, check out the ECHO awards of the Direct Marketing Association.  Award portfolios can often be a source of comparable data on these kinds of results.  Here's the DMA bookstore link to the most recently published portfolio.

Then, devise small tests to begin to get at how close you come to your assumptions.  If it's click rates, or purchases per hour, or acquisition costs, give it a try.  Zipcar, the Boston-based local car sharing service, began in exactly that way. 

Invest just enough capital at each step to validate an assumption. 

Then build a projection based on actual testing. 

Include growth rates as part of this process.  The faster you can see repeatability from customers on the scale you estimated, the better.  You may find that while your initial cost/per is higher than planned, it is OK if your repetitiveness is more frequent than you had thought. 

This should allow you to construct a plan for growth that includes reinvestment rates over time and time to breakeven cashflow.   So, you wind up with a working business model and a projection based on tests that validates both the model and the growth rate. 

And, if the venture meets an untimely end, you haven't over-invested.  (If the assumptions prove to be best in the world by a factor of two based on your research of comparables, perhaps you've only invested time.)

Is Business Model Analysis Important To You?

Investors love entrepreneurs who understand their business model, and can describe it accurately.  And when they meet entrepreneurs that can't, it is often a sign that the management team needs strengthening - at a minimum.

In my mind, a "business model" reveals the structure of the profit engine that underlies the venture.  Most ventures, almost by definition, project high growth rates and substantial profits over some time frame.  In reality, the ability to estimate growth based on revenue for a new venture is low.  There are many, many variables that go into a new venture that make such predictions tenuous at best.

However, it should be relatively straightforward to build a business model that reveals how the business plans to make money.

How much will the product sell for?  (Is that price competitive in the marketplace using comparable data?  If it is a new service, what will it be displacing and therefore what should the price be, etc.) 

How much will the product cost to produce?  What other structural costs are inherent in the business?  Are they verifiable with sales, fixed, or some combination?

How much cash is needed to launch the venture and to achieve cash flow break-even?  When does the venture need the money?  (Can we invest in tranches and therefore reduce some risk as we gain knowledge?)

What are the critical elements in achieving success?  Can we test to find out if these estimates are achievable?  (Are we planning for the lowest customer acquisition cost the industry has ever seen?  And if so, what happens if we are wrong?  Are there ways to figure this out before we commit all of the resources?)

A well thought out business model can then be used to scale projections, again based on comparable experience.  However, total value of projections is vastly less important than a well planned model.