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
As my articles have a tendency to run long, I’m going to favor brevity here to give you a sense for what these mean. If you’d love to discuss more, comment below, tweet me, or let’s grab coffee.
- 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.
I suggest approaching the testing of startup business models with an emphasis on falsification instead seeking validation. The “validation” terminology and mindset leads entrepreneurs astray.
Wow Roger, that’s brilliant. Quite frankly, I couldn’t help but correlate from your reference to “backward industry thinking” to lean validation a different point that I’ve been trying to make that the Lean Product-Market fit is backward. Market first, then Product.
Paul, thanks for this thoughtful piece (and the shout out!). At Bizologie we talk with clients not just about the value which market research has in driving business decisions, but also that industry history is just as important as industry future. A prime example is the grocery/meal delivery startup – what about your iteration of this perennial idea will lead you to succeed where so many others have floundered? How do you scale to multiple geographies when the soul of the business is local, local, local? We recently fielded a fantastic question from a client who wanted to know which other products in her industry had failed, not because of poor product design but because the marketing strategy had missed the mark. She was in essence validating by study of failure.
2,000 likes! Great read Paul! Right on target with 1, 2, 3, and number 8!
Lindsey, great point: industry history is just as important as industry future and I love the grocery/meal delivery example as I’m an old customer of Webvan; color me astounded that here in Austin, we have a half dozen or so grocery delivery startups giving it yet another go without much change to the model.
Chris, thank you. I think 1, 2, 3, and 8 are the most significantly overlooked and the inflection points that separate those who find funding from those who can’t.
This will sound heretical coming from a salesperson by trade but I think we’re too focused on revenue as validation but if selling to enterprises whether ads or enterprise software that’s all that matters. For consumer plays the validation is all in user adoption and eyeballs. As a city we prefer singles and doubles to swinging for the fences. I’m guilty of it too. Chicken and egg problem. Only gets solved when local money misses out on a few major misses.
Great points Chris but I have to debate, “if selling to enterprises whether ads or enterprise software that’s all that matters. For consumer plays the validation is all in user adoption and eyeballs,” with you. I think that’s the root of our problem. Local money believes that to be true and thus so does everyone else. But we’re failing to deliver either of those at any significant scale such that VCs take note and move money to Texas for more than one off investments.
Thus the supposition that that’s what enterprise (or consumer) expects is wrong… or we’re failing to deliver it.
this is good…thanks for posting it and thanks for writing it…i don’t agree with all of it (naturally as you know that is one of the things i like about our relationship–spirited and respectful debate) as usual this is thorough and well thought out…well done paul
What startups (consumer) in Austin would you consider a good model or that you think followed those steps? Homeaway, Sparefoot?
Wayne, no. Indeed, Spiceworks, Revionics, Inc., SolarWinds, TrendKite, LookNook, Gridmates, Plum, Help.com, Neone, RideScout, MI7, CoachTube.com, UnaliWear, Compeat, Tastegraphy, Noonday Collection, Dox, eyeQ, RealSavvy… but then, you say “consumer” and I say “what’s the difference?” (but that’s my Silicon Valley roots coming through). Granted, most of those are the typical definition of consumer but every product/service has a consumer; just because that consumer works within an enterprise and has different consideration in the buying decision, doesn’t change the fact that startups need to be marketing to the individual who converts; not selling to the business that might.
Good post Paul, as usual, and some excellent thoughts on what entrepreneurs should be thinking about as they build their companies. My question is whether answering all these questions is a prerequisite for seed funding or A-round funding? I believe most of the fundraising concerns I heard in Austin were seed-round related. Over the past 9 months I’ve gotten to expand my horizons beyond Austin and, from my limited experience of 1, it’s SIGNIFICANTLY easier to raise seed funding in the Valley, Dallas…and even NW Arkansas!
I was fortunate to be part of two solid venture-backed startups in Austin over 9 years, yet when it came time to raise money for my current company (TryRobin.com) I found investment hard to come by in Austin yet was able able to raise $1.2 million in just a few months in Dallas, NW Arkansas, and the Bay (with a couple great Austin angels like Brett Hurt.) We hadn’t built a product yet, had competitors ahead of us in the space, yet based just on the strength of the team and the market opportunity we found great angel investors from Google, Sevin Rosen Funds, Covara Ventures, and nearly 20 other angels that made their money outside of tech to back us.
I haven’t completely put my finger on why but my initial perspective is that many Austin seed investors are “MBA investors” that focus on all the things you mention in this post, which are great growth milestones but require significantly more time and capital to achieve. This looks like a pretty good list for raising VC money and great questions a VC should be evaluating for an A-round, but for a seed round angels need to understand you’re betting on 1) the team, 2) the market, and 3) the strategy…with the caveat you know the strategy is going to change at least 3x, so you’re really doubling down on the team to be smart enough to figure it out and a market big enough to enable a few mistakes!
In these cities outside of Austin I think you have more wealthy people that are willing to accept more risk, but also more willing to make bets on people rather than an investment banker-like analysis of the company. I’d argue Austin needs a lot more bets being placed on people and a lot more willingness to accept failures and total flameouts. Looking at the Tier-1 VCs for inspiration, I’d bet they have the lowest batting average of successful outcomes, but when they connect it’s a 20x return on a big bet.
The Valley is a home-run hitters market built on thousands of angel investments. Austin feels like a single-hitters market with highly targeted and analyzed bets on a smaller number of more validated ideas. That’s a great way to avoid strikeouts but you don’t hit many home runs when you’re afraid of striking out. The big success goes to the investors willing to swing out of their shoes—they strike out a lot but when they connect it’s a moon shot. But then again they strike out a lot too. 🙂
Great write up on an important and complex topic. Doing each of these steps is hard work (naturally). Bu tracking, documenting, and communicating progress on each of these steps to attract investors, partners or senior-level talent (at seed stage) is also A LOT of work—more than I anticipated. I propose that now we create a product/service (the “O’Brien Scale”?) that helps founders capture and publish this information better. Bring in the historical data, consumer trends, market movement, ETC, to create a “score”. Of course, this would have to be relative to each product/service type, industry, location, stage of growth, and model.
Justin, I think these are the prerequisites to get funded and the extent to which you need to do them and wherein you get funded depends on your results. Companies certainly get funded all the time based on customer adoption and no real cost/benefit analysis nor historical audit; but frankly, that likely means such companies are Angel funded and will struggle to raise later stage capital.
I think you’re right about Austin’s investors. It’s increasingly being said that Silicon Valley’s investors are born of Tech, New York’s are born of Finance, and Austin’s are born of Wealth. I think that’s accurate, evident in how we need to talk with them and the expectations they have. I’m VERY intrigued by your experience in Dallas as I’m also passionate about the fact that the Dallas ecosystem has exploded in the last few years, arguably more substantially than Austin’s.
Were it so simple as being able to set a score Ryon (though have you met Joe Milam?)
“Recruiting is a full-contact sport” truuuue true. #7 in your 12 steps is my favorite. But tons of people are “interested”, the only thing that matters is paying customers and their feedback.
Respectfully Clint, you’re validating my thesis. The belief that paying customers and their feedback is the only thing that matters is the very reason we’re unable to attract and secure later stage capital, at scale, in Texas. Determining what people will PAY and how/where to convert them is nothing more than an exercise in marketing to figure it out; that’s not validating of something scalable. To validate that one has something worth significant investment, with significant potential, 1-6 are more important (not critical nor required) but certainly more important such that what customers think or will pay can become irrelevant if you’ve validated 1-6. I you haven’t validated 1-6 in such a way that you show significant investor potential, then indeed you are dependent on paying customers but in turn suffer from the whims of customers to whom you are selling.
great analysis and article thanks
In my perspective, finding real paying customers who are ready to pre-pay for my product which isn’t being built yet is the main validation point.
Good guidance for those raising funding.
I agree that you’re a bit lengthy and I would take you up on that coffee; if we could. But totally disagree.- the end goal is not to raise money but to have a viable biz. The team needs to learn to work together and there is no better validation than the sales cycle for this.
Not sure when I said the end goal is to raise money. But the goal for many is absolutely not a viable business. Many ventures start to invent something, get acquired, or merely divert taxes. The idea that every startup’s goal is a viable business is a myth.
The goal of a “new business” is to be a viable business. But a startup (a temporary venture in search of a business model) can’t rely on sales cycles for validation – most don’t have any sales cycles to which to refer.
You may not have explicitly. I also read “quickly” but thanks for responding. I appreciate learning new things and to get the chance to exchange points of view is priceless.
In my view, a startup is just a small business. Finding the right bizmod can and should be done before calling the team a startup. The team can and should start selling the mvp or else risk bad product/market fit and become part of the 90% of failures.
“In my view, a startup is just a small business”
Okay, so what then do you call a venture that isn’t yet a business? What’s the word for what Twitter or Google was, in the years before they had revenue/customers?
Hundreds of startups through our incubators has taught me repeatedly that sales doesn’t prove product/market fit, marketing does.
“The aim of marketing is to make selling unnecessary.” – Drucker
I would call them a startup or a team of organized entrepreneurs that will eventually grow into a registered moral person or a small or large business. Still all with the main objective of being able to have constant transactions, regardless of how.
I’m in the dozens; not as many as you have. And precisely, through sales you can better fine tune product/market fit. Certainly sales is not all that goes into the mix, but it is a direct consequence of whatever marketing effort is made.