Is Your Startup Ready For Venture Financing?

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This XSeed blog was written by Venture Partner, Jeff Thermond, and originally appeared on Forbes.

So you’ve got a great idea for a new startup. Congratulations! Before you begin, you might want to think twice about the scope of your great idea.

Put simply, the question is whether your great idea is a feature, a complete company, or something in between? The question may seem to be just a detail or completely unnecessary, but to potential investors, it will be top of mind as they first hear your pitch. And the answer they come up with may put you out of the running before you even get to your fifth slide. Allow me to elaborate:

A little known fact about startups is that most don’t fit the profile for venture financing. The investors in venture know that the success rate for venture-financed companies is low, which means that the successes in the asset class which occur have to make big returns in order to both make up for the companies which did not make it, as well as to earn returns commensurate with the risk of the asset class. The implication of that is that investors feel that every investment they make has to be capable of “returning the fund” or some variation of that very high bar. The second implication is that venture investors often pass on really good ideas because they don’t believe the idea can produce explosive returns.

Perhaps surprisingly, insufficient scope has a parallel at the opposite end of the scale spectrum: Too much scope can also be an issue. This can happen because the venture community by and large has moved on from certain more capital intensive areas where it used to make a lot of money because these areas now require so much capital, they can almost never produce outsized returns on that large amount of capital. My first startup, a semiconductor company, exited in less than three years for half a billion dollars on less than $17 million in venture capital. A very similar competitor sold to Qualcomm a few years later for almost $200 million. However, the company had consumed as much as it took in, and the investment was dead money. Once semiconductors became very capital intensive, they moved into the ‘too much scope’ category and stopped being a business model most firms thought they could make money off of.

So, what does this have to do with the scope of your great idea? Everything.

Say you’re like me, and you can’t figure out how to run a sales operation without some CRM tool such as SalesForce, but you’re disappointed with the tool’s ability to generate meaningful reports easily. You might decide that it would be a great idea to start a software company which would let you easily create a mobile app which would allow sales people to see their pipeline at each stage in parallel with all the other peers of the sales person. This software would be the same as how a sales manager would look at his team’s performance, and it would probably inform a sales person as to how his next conversation with his manager would go. Sales people might adopt this software in droves in order to be better informed, and customer adoption might go viral. The company could be a raging success.

Well, maybe. This kind of idea hews to the ‘feature’ side of the discussion above and illustrates two problems with ‘feature only’ companies.

Firstly, the idea does not have technical differentiation. There are many ways to generate reports out of a database and people have been doing this for decades. That means many people know how to write the code to create this feature, and the product can be easily copied. If this company had compensating factors such as vendor lock-in or network effect, it could potentially make up for lack of technical differentiation. However, this is a mobile application which does not store or create its own data. It can be copied quickly.

Secondly, since the product can be copied easily, there is the high probability of low ASPs for two reasons: many potential competitors might emerge quickly, which almost always engenders a race to the bottom in pricing. In addition, customers will likely be reluctant to pay a high price for something which is limited in functionality.

Notice, however, that this is still a good idea; it’s just not a good venture idea. It can’t produce explosive returns and it isn’t differentiated enough to protect its success from inevitable competitors.

Another area that venture has stepped away from is custom hardware, especially big metal hardware with custom ASICs. (That would be my second startup, which failed.) These ideas certainly have the scope to be full companies, even ones capable of an IPO. However, they require well over $100 million to capitalize fully to an exit. There is great doubt in the venture community that the returns from multi-hundred million dollar investments in startups building custom hardware are going to match the expectations of any fund’s investors.

Given the above, the scope of your idea matters a great deal. Too small an idea means copycat competitors, race to the bottom pricing, and a company which (at best) may throw off a few million dollars a year of profits but will not produce a big pop for the investors in a short period of time. Too big an idea may require so much capital that the return on the capital can never make up for the riskiness of the asset class.

I think the sweet spot for scope (there are many paths to a sweet spot exit for a startup; this article is about the sweet spot for scope) is a company with strong technical differentiation that attacks a large opportunity in a market that has proven its willingness to consider new ideas, products or services. Furthermore, I think the sweet spot for scope is built around the scope of the product where the entrepreneur can get a Minimum Viable Product (MVP) to market quickly and revise the product or pivot quickly if circumstances dictate.

So how is that any different from the “feature” scope, which I argued can be too limited? After all, features can be brought to market very quickly, they can be deployed against a significant pain point, and they certainly can be revised quickly.

The major difference between a “feature” and a sweet spot is “real technical differentiation” (RTD). RTD has many benefits: First, a sweet spot likely can be patented, or alternatively, kept as a trade secret. Companies with defensible IP, all other things being equal, are usually valued more highly than those that do not have this key competitive advantage. In some cases, they are valued more highly by a substantive amount. In my first startup, we had over two dozen comprehensive patent applications filed when Broadcom approached us about a buyout. We negotiated a significantly higher acquisition price than a similar startup they bought which had revenue (we were five months away from first revenue) primarily because the CTO and co-founder was very impressed at the technology we would be bringing into the company. Recent billion dollar verdicts (e.g., Apple vs. Samsung, Carnegie-Mellon University vs. Marvell) in tech IP lawsuits prove that the benefit of strong IP also holds for public companies.

Second, if a company pursues the patent route and makes it clear that it is filing a comprehensive patent base, management is sending a clear signal to its competition that copying bears significant risk.

Third, a company with RTD is signaling that a lot of work has gone into a product, and that is always a good thing to bring up when setting prices, and negotiating them with large accounts. Earlier I noted that feature-scope companies were disadvantaged with regards to pricing because copycat competitors can arise quickly and that a race to the bottom in pricing can occur. When that happens, everyone loses as the profits get sucked out of the market. The more one’s customers believe that a company has a lot of smart and hard work built into a product, the more value they will attribute to the offered solution.

Fourth, I believe a company attracts much better engineers if they think they are both inventing as well as developing an innovative product. Feature scope companies do not have much invention. Great engineers usually aren’t interested in them and I do not believe good entrepreneurs are, either.

What about the opposite alternative, the company whose scope is so big it requires a lot of time to develop an MVP and which is hard to pivot or revise? I previously argued that these firms can consume so much capital they are unlikely to produce the returns venture capital requires. But there is another problem which is just as important: They consume a lot of time to release an MVP.

That’s a problem in multiple ways. The first is that General Partners measure themselves by Internal Rate of Return (IRR), and time is a strong component of the IRR calculation. Two identical returns, but with substantively different time periods to their payouts will produce quite different performances as measured by IRR. If a GP thinks a company’s exit is seven or more years down the road, they will almost certainly worry about the return on the deal being big enough to make up for the investment duration.

An even bigger problem is that the window for market opportunities is usually opening or closing, but rarely stationary. If you see a big market opportunity, but it will take four years to release an MVP, a firm may release its MVP into a market space whose window has already closed because competitors arrived first and signed up the big prospects with a product or service that has a high switching cost.

A third point related to disadvantage number two is that the VC industry tends to be streaky with regards to investment ideas. Clean tech was all the rage until it wasn’t. The same can be said for a lot of life sciences. It’s not good to be half way through your first development cycle and needing to raise money in a market space which no longer has broad scale support from institutional capital.

Finally, great startups listen to their markets carefully. But a really long development cycle delays market feedback about the MVP because a company hasn’t released it yet. There are only so many ways an entrepreneur can tell the same story in PowerPoint before the market says, “Don’t bother calling me until you have something I can trial.” Quicker feedback is always preferable.

So, one of the very first things I try to determine when I hear a startup idea is whether there is a real RTD. Almost immediately after that, I ask myself how long until an MVP can ship to early prospects. If there is meaningful RTD and the development window is not overly long, then I shift to the team and their understanding of the market.

If there’s no RTD, or if the MVP is years and years away, I start listening with a bias that this idea is probably going to be a bad fit for a seed-focused venture fund. And, I would argue, it may not be a great fit for what you want to do with the next several years of your entrepreneurial efforts.

I encourage entrepreneurs to take the time to understand the scope of their great idea and use that as a filter to help them understand how the opportunity looks to the venture community. When you have a great idea, which can be protected, and which has high value to your target market, it can be a thrilling and lucrative experience to build a company. However, when you’re mismatched either to the low or high side on scope, it will likely lead to a frustrating experience. Being conscious of the choice for a startup’s product scope and opting for RTD with a rapid development cycle will put an entrepreneur consistently in the best position to achieve commercial and financial success.