Among the most cited frustrations by entrepreneurs that can’t get funding, is that they have customers and sales, and that they’re being encouraged to get more. And yet…
As we explored in a previous post (“Should I be raising money?”), with the utmost deference and respect to investors, the worst advice you might hear from a pitch to a VC or a demo at an Angel event is that you need more customers. Okay, in fairness, it may not be the worst advice and there is a time your development at which paying customers, at scale, are expected, but it’s usually never at the Angel stage.
Recently one of Austin’s great entrepreneurs, an individual who spent time in Silicon Valley, like myself, before calling Austin, Texas home, wrote about 5 considerations raising capital for an Austin based startup; having raised over $8MM, he pointed out in 3 of the 5 that he’d not raise in Austin again. Why?? Mikael Solomon, co-founder of Edgecase, “My biggest critique of Austin is the lack of access to capital.” What were the three reasons he’d not raise in Austin again and is there, for the purposes of this article, a correlation between the lack of access to capital and solid startup validation?? His brilliant observations about raising money in Austin:
- You can live like a cockroach
- In Austin, the startup community is a family
- Where’s the money at? – It matters.
- Austin would have never funded Facebook
- Recruiting is a full-contact sport
Why not raise in Austin again? I think the reasons are 1, 4, and 5. Yeah, #1 and my reasoning might surprise you.
You can live cheap, but does anyone really want to, and what does it mean for the fund raising process? On the surface, an inexpensive cost of living sounds like a real benefit to a startup community but the challenge that it creates is that you can live inexpensively. You can start a company with very little. You can take more time to draw out your growth, chasing a handful of customers to get by and creating what’s really just an illusion of success. At the end of the day, a company that can get started on $250k in Austin, perhaps so in your city, requires $1MM seed in San Francisco and while the low cost affords time, capital is king and financing creates options, attention, and an attraction that helps companies scale.
In pointing out that Austin would not have funded Facebook, Solomon adds that, “the fundraising scene in Austin is staunchly focused on companies that can show strong revenue or traction.” Interesting, now you appreciate the context of my thesis. Why is Austin staunchly focused on companies that can show strong revenue and yet, presuming we’re successfully delivering that, we have seemingly little access to capital? He adds, “revenue growth is not the right investment thesis for capital intensive or billion-dollar, ‘change the world’ companies.” So what is?
But before we explore how to really validate a new venture, let’s tackle what I think is his third reason, that recruiting is a full contact sport. At the end of the day, investors look to teams first and fund successful, proven professionals and executives. But if your startup community isn’t able to raise much later stage venture capital, if your community results in startups that exit around $100MM instead of the hundreds of millions, experienced professionals aren’t willing to take the risk involved in the long hours and underpay of a startup for the validation of a few paying customers and an exit that might net them a few hundred thousand dollars. Recruiting is a contact sport because a smaller economy is fighting over the fewer opportunities that might yield real wealth. And investors are aware of that challenge entrepreneurs have to overcome to build companies worth investment!
Thus the question, how do we effectively validate ideas so that investors stop ignorantly encouraging, ‘more customers,’ and start focusing on the real business fundamentals that result in significant success? What are those business fundamentals??
The 12 Steps to Startup Validation
- Market gap: Do you know your industry, competitors, and demands of potential customers and partners? Start with solid market research whether you do that yourself with tools like Google, Quora, and Marketing Charts, bring in a consultant such as John Heintz or Steve Pearson, or turn to a firm such as Bizologie, leave no stone unturned. If you’re in an incubator, this is what they should be helping you accomplish, at the very least.
- Historical analysis: Understand the industry from which you come. Who has tried this before and failed? Why have they failed? Why is what you’re doing now more likely of success? What are the historical considerations of constituents, partners, and potential customers. What are the economic considerations that make today, where you are, meaningful? Here’s where it’s important to remember that your idea is not nor original, know the past to alleviate the concerns of those who do.
- Cost / benefit analysis: What does it cost to acquire an audience? A customer? Market share? What is the benefit you’re delivering to the market relative to others and how is the value of that benefit greater than the cost? Keep in mind what’s called switching costs: i.e. I don’t care if your social network is better, I’m not switching from Facebook when my entire life is there. Now answer the same questions from the investors’ perspective in the context of their costs and benefits; yes, THEIR costs and benefits. They have opportunity costs and investing in you had better offer better potential than investors’ alternatives. How do you this?? Market research.
- Website adoption: Build a loosely related website be that a blog post on an industry blog, your own blog, or a landing page explaining your new business. Now show me organic (natural) growth by way of Google and social media. If you can’t even generate traffic to a website, increasingly over time, how are you going to sell anything??
- Social media interest/reaction: Does your Facebook Page, Twitter, or LinkedIn Company page have followers who aren’t merely your friends? Does it have engagement on any posts you’ve shared about your industry, progress, or news? But wait Paul, we don’t have a consumer product, we’re building Clean Tech Hardware, why would we Tweet!? You wouldn’t. So show me support on the channel wherein your audience is found. StackExchange? SpiceWorks? Everyone is online and everyone is social somewhere, show that they care.
- Media or blogger interest/reaction: NOT COVERAGE, Interest. The constituents most likely to know your industry and most capable of determining your success (or failure) are in the media. What trade publications, conferences, bloggers, local reporters, and national editors are intrigued by what you’re doing? What’s the story you’re telling them and what has been their reception? We’re not looking for articles yet (and certainly not press release-like announcements); we’re looking for interest from the individuals in your ecosystem who know best all of the other players and who are likely, or not, to tell your story.
- Potential customer interest: Having established and communicated everything thus far, validating that what you’re doing has potential, you should be able to close Angel investors here. And this is where the rubber meets the road… an Angel should be interested in funding you having validated thus far in order to close the gap needed to nail down potential customers. This is where Letters of Intent, emails affirming interest, beta subscribers, and more help validate that not only does the market what what you have but customers are ready to convert.
- Potential angel investor interest: Wait…. Angel interest (not investment but mere interest) is a sign of validation? Of traction? It most certainly is. In fact, now is a good point to explain how to work through these steps as though I’ve directed that you need to work through them in order, you can probably point out where you had an Angel investor in spite of failing to establish one of the former 7 considerations. Indeed, that’s possible. An Angel investor without any of the steps 1-7 effectively validates you to this point but not beyond! Venture Capital won’t fund you just because you have Angels and you need to from this point, validate that you can scale before VCs will even listen. Point being, you can certainly validate from any point in the 12 steps but appreciate the implications of doing so and appreciate that validating by way of the previous steps all but makes the next step simple.
- Early (non friendly) Customer adoption: The next step is simple? It is if you’ve validated the previous steps. How do you convert non-friendly customers (people you don’t know nor whom live in your city)? You bring to market a product they way, at a price/benefit that’s compelling, with social and media validation to give you some credibility, and some Angel investors who are taking a risk with you…. early customers will sign on the dotted line. But if you’re starting here… if you are following some advisor/investor direction that you need customers first, you’re having to SELL them something and Sales isn’t scalable. More importantly to remind of you Mikael Solomon’s point, revenue growth is not the investment thesis behind billion dollar companies. A round about way of saying, you can’t get to step 12 on step 9 alone!
- Customer retention: Start but understanding what relevant retention means. By the way, this is one of the most important metrics for larger rounds and Venture Capital and the best way to appreciate and understand this is to again refer to Sales; anyone can sell anything to anyone… the only reason you are worth investment is because you have something people actually want: you can retain them. So, for example, I tend to turn over mobile apps every 6 months. So if you’re creating a mobile app and people stick with you more than that… that’s meaningful. If you lose too many people after only 30 or 60 days, you aren’t getting funded. So what is a meaningful retention rate and how can you establish for your potential investors that you outperform that?
- Customer referral: The most fundamental step beyond retention is referral. Why can’t you get funded? Because you haven’t validated that your business is scalable. That the investment results in a multiplied ROI. How is an investor’s investment multiplied? Not because you can sell something but because selling something to one person results in three more customers. No idea how to measure retention and referral at this stage? Start here and make sure you have a Marketer on your team.
- Venture capital interest: Like Angel invest, you might be thinking how is VC interest a point of validation? Like Angel investor interest, a VC having interest in what you are doing helps you leap over the previous steps and close funding in spite of your lack of them. You have the story: the subtle frustration, “How does John Doe keep raising capital for new ideas?!” Because John Doe has already validated that they are worth investment based on their previous success or contribution; now John can raise capital for new ideas without much in the way of validation from the previous points.
Now an interesting debate; a good question: do these points of validation apply to both software and hardware? How can social media make sense for enterprise and is a retention rate really meaningful in an early consumer company?
Most important is not the significance or approach to your application of these point but rather your staging. 1 through 12, in that order. An enterprise hardware company, for example, should have no problem finding some social validation on Spiceworks, StackExchange, or Quora; not thousands of Facebook fans as validation but failing to show any fans, anywhere, is a red flag as it’s not difficult to accomplish.
Would I start another company in Austin again? Solomon added:
“It depends – I probably would if I were planning to bootstrap and never fundraise, but if I wanted to build a consumer business or a company that was disrupting a market, then most likely, no.”
So if you need to fundraise, how do you validate what you’re doing in such a way that investors are pre-sold? Start at square 1 as if you can’t explain the market gap, you have no business being in business. Then know and explain the history of your industry, market, and product, followed by your embrace of the costs and benefits involved in your space. With that, you’ve validated an opportunity worth an investment of something so now show you can simply get and grow an audience by way of meaningful website adoption: traffic, repeat visit rates, or the conversion of visitors to specific pages. With that, them media will hear your story. Are they listening? Not reporting an announcement nor willing to cover your raise, are they intrigued by what you’re doing, where, why, and how? Only then can you affirm that potential customers are really interested in what you’re doing – customers beyond those you already know or whom want to see you succeed as fellow entrepreneurs and professionals where you live. With that, Angels should be beating a path to your door and closed customers have nothing to do with your success as Sales alone are no such evidence of it. With Angels, you can take the next steps necessary to close commitments to customers and indeed, before chasing VC, not Angel, you need to now close that business as Venture Capitalists are seeking repeatable evidence of scale; that is, not that you can close customers but that you can retain and that they are willing to refer.
Think I’m wrong? Refute me below and let’s explore publicly what you’re doing. Perhaps, you’ve not validated the steps that come before the step at which you believe you find yourself. Are you really certain that there is a gap in the market worth funding? Take the time to establish that as the first gap in your pitch is going to come from the investor who points out what you’re wrong.