The most difficult task faced by both entrepreneurs and investors is not only obtaining resources or making investment decisions, but also assessing the chances of success in the proposed venture. This note is an attempt to outline some of these steps and areas of investigation.
Investment in early stage ventures is fraught with risk, both for entrepreneurs who invest their most valuable commodity, time and attention, and for investors and their capital. This single fact is also the reason for the potential for outsize returns.[1]
Both parties should consider both the company’s ability to demonstrate planning skill, including coping with the inevitably unknown issues, and at the same time focus on “what can go right” so as not to fall victim to an “avoidance of loss” bias.
Planning Skill in Pattern Recognition
The odds against a successful outcome in a startup investment are very high. Venture backed startups have a failure rate, depending on whose statistics you believe, of 50% to 75%. To reduce the odds of failure in venture backed startups, the venture needs access to substantial experience in pattern recognition and a successful working relationship among the venture’s leaders and investors.
A definition of a successful startup investment (return of more than capital invested) consists of selecting ventures with good product-market fit and an achievable plan to reach a sale of the venture (the most likely case), an IPO, or a cash flow positive status in a timeframe supported by available resources.
Choosing ventures based on these criteria, whether as an entrepreneur or an investor, is an idiosyncratic process that includes a lot of pattern recognition ability across a relatively wide category of topics. And, it almost goes without saying, it requires an inspiring leader who can understand customer needs and team building in tandem.
Lets think about pattern recognition
It’s inarguable that chess masters have experienced thousands and thousands of repetitions that have built their repertoire. It’s a game of colossal variation, but within an established set of rules and patterns. Feedback is instantaneous and definite.
In other professions, (such as choosing startups,) there is endless variability and little correlative feedback. My premise is that there are certain patterns that repeat themselves. While none provides certainty for a good outcome, these patterns can reduce errors that are all too common in startup failure. In other words, experience in the startup world is repetitive and predictable, and, given years of prolonged practice, it is possible to learn (some) of these patterns and probable outcomes. [2]
The trick is to recognize the pattern and act to test its validity. The testing task usually falls on the entrepreneur, while it is frequently the venture investor who has the preponderance of pattern recognition experience. Often the entrepreneur has less prolonged practice but all of the execution responsibility and the investor has more prolonged practice but is not responsible for execution. The successful outcome of the ensuing dialog forms the basis for the success of the relationship, and probably for the investment as well.
Entrepreneurs are almost always undiversified. Their net worth and their emotional commitment is often tied up in their venture. The enthusiasm and single mindedness that (must) accompany their planning can also cause them to under-represent risks to both themselves and their potential investors.
For those potential investors, if they do not accompany the process of insight based on experience with empathy and understanding of the entrepreneur’s world, chances of making much progress are limited.
This requires slow, thoughtful analysis that avoids the trap of a quick decision based on an overly simplistic analysis.
Daniel Kahneman, the world-renowned behavioral economist, describes this kind of decision as one that may be susceptible to the availability bias.
That is, instead of answering a hard question that requires real work, “What variables and conditions in this investment make it worthwhile or too risky?” The investor substitutes an easier question: “Have I ever seen an investment that may be similar to this that failed?” and answers that one instead.
For investors who persistently use this method, access to opportunity will probably be very limited.
When an investor has initial interest, the ability on the part of the investor and entrepreneur to explain patterns and share helpful experience is of paramount importance.[3]
The Planning Process
Kahnemann describes the Planning Fallacy as a series of tacit and specific assumptions that can lead to poor outcomes based on underappreciating the “base case” for similarly situated startups. Investors and entrepreneurs who also understand this fallacy can help guide companies to better outcomes, assuming they can answer the risk based question posed above.
Entrepreneur-Planners can:
- Assume best case outcomes;
- Undervalue competitors, their probable reactions, and capabilities;
- Believe the team’s capabilities are complete and world class;
- Assume limited resources at hand are sufficient or that future resources can be obtained on good terms;
- And therefore create execution models based on the belief that everything will go right.
Entrepreneurs must guard against plans that are the embodiment of best case scenarios and at the same time ignore statistics about success rates. This orientation, guarding against plans that are only best case, is the first job of the leader of the enterprise.
An entrepreneur with prior startup experience typically possesses valuable learning on these topics. It’s probably also why growth stage companies tend to hire leaders with prior growth stage experience.
Competing for resources is a major component in why entrepreneurs generate these overly optimistic plans and projections.
If the over enthusiastic or inexperienced investor correctly likes the venture but endorses these overly optimistic plans, that won’t guarantee their continued acquiescence when things don’t go as planned, and this can put the venture in a very tough position. It can become cash poor, and at a time when variations to the plan create doubt as to the venture’s viability. This can lead to a series of difficult financial situations.
Most next round investors ask what the opinion and appetite for reinvestment of early stage investors is.
A double check here is what Kahneman calls the inside view versus the outside view.
He describes the Inside View as the one that focuses on the specific circumstances of the project the entrepreneur is planning, and uses his own experience to build plans. So, a timeline for things inside their control, like developing a technical product, are assumed to be known. Assumptions about customer actions are also assumed based on internally generated analogous experiences.
The inside view, he points out, is “spontaneously adopted” to describe the venture. It fails to take into account the probable delays, unforeseen consequences, customer and market issues that inevitably arise. (From here probably comes the adage about planning to invest twice as much and take twice as long for a good outcome!)
The Outside View, on the other hand, focuses on similar situations and is often the “fresh set of eyes” that most planners will say they value.
The outside view requires both an outsider with an informed ability to assess the plan, and a “reference class” of startups to assess the average time and cost required to achieve similarly hoped for results. It tells the entrepreneur where the ballpark is. And it requires a thorough understanding of who else is in the market and what their likely reaction to the new venture will be. It’s often disheartening and suggests more investment will be required as time and cost is much longer in a success scenario, based on the reference class. However, it’s far superior to have this information early enough to adjust plans, or even abandon the venture.
Entrepreneurs who understand this can expose themselves to information to reduce their risks and position themselves for good outcomes.
One way to frame this on a practical level is to create a framework for the venture that may include a number of categories for exploration. For example:
- Team Composition, experience, capabilities, gaps and commitments
- Business Model including Revenue and Expense Model and contingencies for shorter or longer adoption times
- Sales Process, concept, costs and alternatives
- Evidence of customer demand
- Competitive Environment
- Reference planning cases
While none of these is an answer to the “is this a good investment?” they can lead the way to uncovering opportunities, biases, and areas where positive contributions can be the hoped for tipping point in the enterprise.
[1]. In fact, worth noting that potential is asymmetrical; the investment upside is theoretically unlimited and the loss is limited to the cash invested minus the tax benefit. (In Wisconsin investments, that includes a 25% tax credit. In some QSBS federally qualified investments, the first $1MM can currently be taken as an ordinary loss.)
[2] Many entrepreneurs have significant industry knowledge and expertise. This often forms the basis of the venture. Where first time entrepreneurs may sometimes have less experience is with the rest of the venture’s requirements including business model dynamics.
[3] Further reading: “Thinking Fast and Slow,” Daniel Kahnemann, Farrar, Straus & Giroux publishers, 2011.