Equanimity Insights : What we look for while evaluating investment in an early stage business
As investors, we get the opportunity to meet thousands of entrepreneurs each year. As far as we can tell, every single one of them is passionate about their idea, believes it will create immense value and wealth by creating a positive change. They have spent hundreds of hours planning the details, have sought out mentors and well-wishers to get their advice and are on their way to give concrete shape to their dreams. The question that we keep getting asked and more importantly, keep asking ourselves is:
What do we look for in an early stage business? We think about this deeply. What is it that inclines us to support an entrepreneur on his journey of a lifetime? We confess there is no simple answer to this question. We continue our quest of fine-tuning our answers and the background process by which we want to arrive at these answers. This is our attempt to share with you our thinking about these problems and their answers.
The most important factor that we seek out in businesses is, yes, you guessed it right, the TEAM.
If you’ve ever been to the races, there is this entire question of what do you put first: the horse or the jockey? Our answer is and has always been: jockey. Our belief is that the best product or solution can become a cropper if it is not being driven by an outstanding founder and/or founding team. We want to see not only a good team but a team that is complimentary. We like co-founders that have come together by virtue of their ability to create value and wealth for all stakeholders and are not there for any extraneous reason. We spend time understanding if the team has a shared vision and a culture that breeds cohesion. While we like to see uninhibited ambition in the founder, we seek a balance which comes from traits like humility, self-awareness and an eagerness to learn and take feedback. We want to see cap tables that have been drawn out well with each co-founder and the key managerial team having adequate skin in the game. We want to see a decent board of advisors and mentors. Not every business we invest in will have all these factors but there has to be a shared understanding on these subjects. There has to be a willingness to sort these issues out before the business takes in any external investment.
The second most important factor that we seek is a SIZEABLE MARKET OPPORTUNITY.
One of the major biases that abound in the entrepreneurial ecosystem is the "my product or solution is needed by everyone” bias. A business idea is certainly an entrepreneur’s baby but one has to be realistic about the baby’s future. We are excited by ideas and businesses that are addressing a pretty sizeable market. India, fortunately for us, is a large consumption market and supports a host of B2B and B2C and its many variant business models. The key is to employ scientific research in figuring out, upfront, how big the addressable market is. Entrepreneurs who take the trouble of estimating their addressable market size, use a few mechanisms as outlined in the table below:
Source: Hungry startup strategy: creating new ventures with limited resources and unlimited vision. Peter S Cohan Berrett-Koehler Publishers Inc. First Edition, 2012.
Once they have an idea of how large the addressable market is, they can dissect this large market and figure out which part of the market should be addressed first and why. Much like Amazon, as they started with books but soon spread their product range to pretty much everything that consumers want to buy. From our standpoint, it is risky to invest in businesses that focus on a smaller market. There are far too many variables that an entrepreneur is juggling with in ensuring survival and growth. Consequently, there is much that can go wrong in early stage businesses any which way. By investing in a business that addresses a small market, the risk is that much more enhanced. We must add that there are many niche markets that can be addressed using technology to deliver required products and services and they can provide profitable investment opportunities too. Just that our investing philosophy doesn’t gravitate towards these models.
Once we derive comfort with the team and the size of the market opportunity, it is time to focus and understand the COMPETITIVE LANDSCAPE.
We cannot highlight the number of times we have heard, “We are totally differentiated. We do not have competitors”. Well, guess what? In today’s day and age, competition is a given fact of life, unless you are an innovator working with the sciences or cutting-edge technology that you have patented. The world is indeed flat, as far as competition is concerned. What an entrepreneur is creating in India has real-world competitors from the Silicon Valley, Israel, China and practically from all over the world. We have seen that even within an ecosystem, competitors swarm in as they see an opportunity that any single startup has been moderately successful in addressing. We need one bike company to be successful to see another fifty entrepreneurs spring up overnight trying to address the same market in their own differentiated manner. Sometimes entrepreneurs dismiss competition to sound confident and not really come across as being in a tight competitive situation. We understand that. What really scares us is if they believe that they are indeed unique and do not face any competition. This is the essential difference between knowing what one doesn’t know and not even knowing what one doesn't know.
Next in line, in terms of importance is the BUSINESS MODEL.
We use this term loosely to include all important facets pertaining to making the business appealing to its customer base and at the same time helping the founders in building a sustainable business. A few areas that need to be thoroughly thought through are:
Specific market segment focus: which part of the overall market should the business focus on, to start with?
Customer value proposition: ensure that the business is solving a ‘real’ problem and delivering customer value leading all the way to customer delight.
Sustainable competitive advantage: this is the area that should keep the founding team awake at nights. Yes, this is the era of being paranoid and yes, mostly the paranoid survive. Business does happen at the speed of thought and if your team is not running to keep ahead, look out for the swishing sound of competitors breezing by.
Pricing & Distribution: these are critical to any go-to-market strategy as these are the pillars that will ensure what you are rolling out is indeed sustainable. At startup stage or early stages of the business lifecycle, mistakes in pricing and distribution can be lethal.
Understanding costs: this is an area that is the nemesis of a large percentage of failures in the early stage ecosystem. If you are setting up a business to tackle sizeable global problems and deliver customers value, you cannot shy away from understanding numbers. The most important numbers for an entrepreneur in the early stage ecosystem are costs.
Understanding cash flows: flowing from the last two areas of pricing and costs is the cash flow. I think of this as the holy grail and have rejected most business plans since I came away far from convinced about the sustainability of the planned cash flows. This is a mix of art and science and we understand that. There are bound to be many deviations from the planned cash flows in the real world but we do need some basic assumptions to start from. We need some sort of plan A even as we keep plans B, C, D and E at the back of our minds.
This, in a nutshell, is what we look for while evaluating investment in an early stage business. Before we conclude, allow us to share some research about how founders think about their priorities. Here is a simple chart outlying a few areas:
Source: Harvard Business Review: What does an aspiring founder need to know?, Thomas Eisenmann, Rob Howe and Beth Altringer. June 21, 2017. https://hbr.org/visual-library/2017/06/what-skills-should-an-aspiring-founder-prioritize
From an entrepreneur point of view, it takes a lot to build a successful business. From an investors point of view, it takes a lot to identify the right investment opportunities and then work with the team, plans, etc. to build long term sustainable business. What we can assure you is that when the right entrepreneur meets the right investor, they create magic.