One of out three is the best you're going to get.
After rummaging through quite a few business plans lately, looking at new startup ideas, and chatting with investors about what they're looking for in this crazy market, it became pretty apparent that VC's aren't telling the truth about their investment criteria. They say one thing, but it always turns out differently.The thing startup executives hear over and over again is that VC's invest in:
- The Management Team (first and foremost)
- The market and market growth
- The technology or product
I hear quotes like:
"If the management team is solid, they can innovate through anything"
"The first version of the product is rarely the version that sells"
"The technology has to be just 'good enough' if the market is the right size"
When is someone going to call BS on VC's when they spew this stuff? Venture capital investors understand financials, leverage, and some even understand technology. Most do not understand how to interview or hire good people, and most (using extreme blog liberty to make sweeping generalizations) don't understand operations or how to launch a new product successfully. How can I say this with so many successful investments? Precisely because there are so many more unsuccessful investments. VCs say they look at people, market and lastly technology - but it's really the other way around. It's apparent as evidenced by their investment criteria and their investment track record.
Market Size
Vetting a typical deal involves market sizing and potential growth - calling on industry analysts, market leaders, and other investors to determine whether they think there's a market and how big they expect it to be in 3 years. 19 times out of 20 these numbers are optimistic (at best) or just plain egregious. The accurate representation of market size or growth for a new technology or new or nascent market is virtually impossible. But having analyst or expert validation somehow makes it all OK.
Speaking with initial customers / reference customers / prospects is also a common evaluation exercise. This is better as a determinant of a company's success, but it's much more complicated than that. VC's call their friends, CTO's they've developed relationships with, and people at big consulting companies to talk about the validity and usefulness of the product. Good investors get some pretty good information. But, calling on these people can also be misleading, since they might not be representative of the market as a whole. Calling on a company's early customers is a problem as well. Any founder worth his salt can sell a product to a friend or colleague or two. Almost anyone can sell one product to an enterprise for less than $50k - under the budget approval radar - and that's the sweetheart deal that so many technologies get 'proven' at.
VC's go back to their board rooms and say "Yes, people will pay for this" because Joe at Fortune 500 bought it, so others will too. This unfortunately doesn't lead to any understanding of whether the sale is repeatable by a non-technical (scalable) sales team.
If investors REALLY and truly cared about the market or market potential, they'd do a ton more work here. Work that takes more than a few phone calls and a few days to complete. They'd have the company do real market research, prospect calls and focus groups, and they'd demand that the company put a product marketing pro in place as part of the executive team.
Understanding a Market
In doing what I call a "360 Degree Analysis" you can really determine whether the market is ready for a new technology, who the buyer is and what their motivation is, what the use case is, and what budgets they can pull from. This analysis is a rigorous, scientific assessment that combine qualitative and quantitative data from surveys, interviews, and focus groups. Without in-depth understanding of potential customers and potential buyers in different departments of target companies - across industries - market readiness will just be a guess.
The most important result of a 360 Degree Analysis is a Buyer Persona. A buyer persona is different than a User Persona, but similarly it's a picture of a "real" person and all the influences on that person. It will answer questions like: Who is the buyer? What do they look like, who do they work for, what problems are they trying to solve? How do they get budget, how big is the problem, and how visible is it inside and outside the organization? How much budget is currently allocated, and where is the project on the year's list of things to do? Most importantly, what are the buyer's motivations?
Market size isn't enough - to really understand whether a technology can be sold, a clear picture of the ideal customer and buyer, the sales cycle, buyer's needs and timeframes must be painted.
The bottom line: if more companies vetted their exact buyer persona BEFORE funding, I would bet a dollar that more than half wouldn't get funding at all. Probably more like 60%. They wouldn't find a repeatable buyer, they wouldn't find usable budget, or they wouldn't find the "problem" they're solving exists or is painful enough (yet) to do something about it.
CAVEAT: In the B2C web space, where there is very little buying cycle involved, its really really hard to do any sort of pre-market testing of an idea. Consumers can't typically understand or explain whether they like something or would pay for something without seeing it first, so the 360 Degree Analysis can only go so far without a Beta product. But for a B2B enterprise software or SaaS solution, there is no excuse.
Executive Team
The most likely reason this exercise isn't done before or during due diligence is the team. Although a strong executive management team is the first on the list of criteria most VC's will say they're looking for, it's almost always the last.
Most technologies are built by technologists who call on one reference point in building a product - their own personal experience or that of a family member. Some technologists have more connections and a broader understanding of users but in my experience there are very few that understand the motivations of buyers. Someone with product marketing or product management experience is required to do this type of extensive market research, and usually those people aren't sought until after an A round, or even after a B round. Many executives expect sales people to have the knowledge to hunt and find buyers armed with only a description of the technology and what it does. It takes a rare salesperson who used to be in a buyer role, or a very experienced (very expensive) salesperson to talk about buyer problems in such depth that they can glean motivations. Even more rare is a salesperson who can talk to 10 prospects and extrapolate commonalities about buying patterns and be able to communicate that back to the executive team, especially R&D.
Not having a strong, senior product marketing executive as part of the founding team adds directly (and significantly) to the time and cost of selling a new product - it takes between 6 months in the best case and 3 or more years of continuous funding in the worst case for some companies to a) find the right buyer and buying situation and b) be able to replicate that across multiple customers.
What about the CEO? you say. Typically a CEO comes with this type of understanding of a market and market motivations, but rarely does a CEO have time to do all the work required for a good 360 Degree Analysis, never mind document a persona and create all the collateral to train and arm a sales team. But, a great CEO will recognize this and will find someone quickly to get it done. Maybe that's what they mean about a "great executive team" - a group that understands what they don't know, rather than what they do.
Great Technology
So, where does that leave VC's? Investing in great technologies. Things that they think are cool, are game changing, market disrupting innovations but aren't necessarily products that can be sold for a reasonable amount of money. And some of them are successful...but not because anyone knows for sure before the investment, but because the VC "feels it" and can convince their partners it's a good bet.
Great technology is why most companies, especially B2B companies, get funded. VC's bet that someone somewhere will think it's as cool as they do, and be willing to pay for it. I'd like to think that the investors that want to build a more solid portfolio will realize this. 'Home runs' in this market just aren't possible anymore, so putting together a portfolio of 'singles' and 'doubles' is the real way to provide a solid return to limited partners. I see venture capital firms moving this way, and I predict that the best ones will start to bring product marketing expertise in house to do formal, rigorous, scientific analyses and create buyer personas to help them understand the real buying cycle before investing millions.
