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Venture capitalists, especially those that focus on financing
early-stage technology companies, get bombarded with proposals
outlining business concepts at various stages of development. To
give you an example, the staff at one prominent US based VC
consider about 12,000 business plans in any given year, and
finance about 15. To deal with such volumes, VCs must quickly be
able to sift through such concepts by determining the answer to
some key questions.
Internet entrepreneurs considering raising venture capital to
finance their companies would be well-served by asking similar
questions of themselves and judging the quality of the answers they
are able to provide before they start making the rounds.
To begin with, there is a set of questions that is relevant to
any business concept, internet-related or not:
1. Who is the customer and what is their pain that is
relieved through the new product or service?
Obviously, products and services that address real,
significant customer needs are preferred to business concepts
that are useful to very few customers, serve a marginal need at
best, or have multiple pretty good substitutes. Enough said.
2. How do you make money?
Surprise, surprise! Especially with technology businesses,
business models matter. This is not meant to suggest that VCs
are naive enough to expect business models to remain rigid over
time, or to expect that entrepreneurs will have all the answers
about how a new product/service can be priced from day one. What
VCs look for in the early stages is a plausible roadmap leading
to an extremely profitable business down the road--fully
realising that the roadmap will undoubtedly change multiple
times in the course of the business.
3. Why is the addressable market really huge?
"Huge" is the operative concept here. Not tens or hundreds of
thousands, but millions and millions of dollars. And these
millions need to be directly linked to the core product/service
the new concept will address-hence, "addressable" — not
peripherally, kind of, maybe, by extension, one could argue,
someday the business could have access to these sums.
4. Is it unique?
VCs tend to shun "me-too" followers.
5. How will you change the world in new and innovative
ways?
6. Who is the competition and what is your "unfair"
competitive advantage?
How do you win out over all others?
For technology-related business, aside form these fairly
standard questions on business concept validity, there is
another relevant set of questions that are somewhat more subtle.
These questions seldom apply to traditional businesses but can
make all the difference between a multi-million-dollar concept
and just another good idea-when it comes to technology
companies.
7. Does the business concept lead to positive
reinforcing network effects?
In other words, does the value of the product/service
increase with higher use or distribution? If such positive
network effects are present, then a first-mover advantage
coupled with decent execution and customer retention can
translate into a tremendous barrier to entry for subsequent
competitors.
8. Can the business concept be implemented in a way that
scales with the growth of the opportunity?
Transaction-based pricing and variable pricing models allow
for more upside than flat rate, one-time licensing deals.
9. Are there innovative marketing and "spread"
techniques, like viral marketing that can leverage the full power of
the web to promote the business concept?
The special catalyst for Hotmail’s torrid growth was "Viral
Marketing" — not because any traditional viruses are involved,
but because of the pattern of rapid adoption through
word-of-mouth networks. Every customer becomes an involuntary
evangelist for the company, and by using the product, they
spread the marketing message to their friends. Viral marketing
powerfully compounds the benefits of a first-mover advantage,
and it’s something VCs eagerly look for when evaluating any
technology start-up company.
Lastly, there is a set of questions that deals more with the
execution of the business concept. At the end of the day, ideas are
cheap, whereas building great companies that will stand the test of
time is very difficult.
10. Will you adapt?
The Internet is a disruptive technological dislocation. We
are in an economic milieu where everything is changing quickly.
Start-ups have the advantage of being nimble and being able to
change business plans dramatically on a dime. Especially in the
Internet era, a company’s competitiveness seems to depend on its
velocity of thought and action.
11. What are the barriers to entry?
Companies can grow more rapidly than ever before, but so too
may they suddenly die from obsolescence. The critical
differentiator is whether the company has built in switching
barriers for its customers and barriers to entry for its
competitors. Rapid growth is of no value without customer
retention. Whenever VCs consider an investment in an Internet
start-up company, they strategise about customer switching
barriers, and the impact of the inevitable arrival of
competitive imitators. The Internet supports an ecology of
organisms, and the "fast follower" is a classic form.
12. What are the key institutional skills needed to
successfully execute the business concept?
Which ones are already present and where can you find the
missing ones? Early stage VCs seldom see complete teams — and
that’s OK. What is important is that the entrepreneurs be
realistic about what their current team brings to the table and
recognise potential management holes. Even the most brilliant
business concepts don’t execute themselves.
13. How much money do you need?
VCs will always have their own opinions on this question, but
you need to set expectations. Tying financing needs to risk
mitigation events is always a good idea (i.e. raise money to get
you to the next big set of milestones, then expect to raise more
at a higher valuation, if all goes well). Choosing your
early-stage investor is one of the most important decisions you
will make-don’t lose high valued-added investors over quibbling
for valuation. Remember, the value at the end of the tunnel is
the only one that counts — and getting the right partners on
board is the surest way of speeding your business concept
towards it.
14. What are you in it for?
This question is often overlooked, or taken for granted by a
lot of people, but is one that has to be clarified early on to
ensure alignment between entrepreneurs and VCs. Some
entrepreneurs are passionate about the space they’re operating
in and want to change the world in some significant way; others
are in it primarily for the money; yet others care more about
their role than they care about the concept itself. Ask this
question of yourself and then make sure that your partners
(investors or otherwise) are clear on your motivations in order
to avoid surprises and potential clashes later on.
Business models should be:
Realistic: Built out of believable
back-of-the-envelope assumptions on key operating metrics such
as revenue per customer, acquisition costs, margins etc.
Internally consistent: Claming value
proportionately with value created by the business versus its
partners.
Unbounded: It’s always good to be able to make
unlimited amounts of money out of your customer base. There
should be no cap on the upside, such as a buyout contract with a
larger firm. Avoid people bottlenecks to scalability. Often the
young technology company finds that its growth is constrained by
its ability to hire good people. This is why many of these
companies try to engineer around people-intensive elements of
their business, such as consulting and customisation.
Consider a "market shrink" strategy: By lowering
prices or offering free products, the new entrant can make it
very painful for established companies with established
distribution relationships to follow them.
Gain significant share by restructuring the basis of
competition: The new market size may be smaller,
driven by Internet price efficiencies. There may be less revenue
in a free email market, but it’s tough for Eudora and companies
based on selling client software to follow Hotmail’s lead.
Obviously, there are many variables outlined here, and on top of
that, the technology changes every day. It’s as if business were a
game of chess — competitive and rife with strategy — but with the
added twist that at any moment, a new piece may redefine the plane
of play.
Suddenly, an incumbent technology business may find that the game
has been redefined into a third dimension, and they have few pieces
on the new playing board. Think of your business strategy as an
iterative game, but keep your mind open to restructuring the playing
field, especially with business models that are possible only on the
Web.
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