Doing due diligence on startups can be like trying to put fog in a box. The variables can shift ethereally or disappear altogether when the sun shines on them. But you still have to try. To that end, Dave has created a checklist of 10 important factors he uses to gauge the viability of a startup. In this episode we go through them all, with gusto.
We’re doing a continuation of last week’s podcast. You had mentioned and teased the 10 factors that SeedFunders considers in deciding how to proceed with a startup that has asked for money. Let’s dig into some of those. Let’s start with the product or service the company offers. What do you look for there?
First, we like to see that there is a product or service. This can be Minimum Viable Product, often called an MVP or prototyped, but there has to be some there, there. We don’t invest in ideas. There needs to be something we can test or try or analyze, to make a decision as to whether we want to proceed with the due diligence. First of all, there needs to be something there. Next, we want to see that it solves a problem. We’d like to see a clear issue and a solution. So, we can be convinced that people or companies will actually be interested in buying the product or service. We often see what we call a solution looking for a problem. It should be the other way around where the problem is identified, and the solution is developed.
Third, we want to see scalable technology. This can be software or SAAS system that is deployed over and over once it’s developed, or once deployed creates some recurring revenue month to month. Such as a product that’s installed. That there’s monthly subscription fees or monthly monitoring fees. Those types of things we consider scalable technology, and includes recurring revenue. Finally, we’d like to see B2B, what’s called business to business businesses where they sell a biz to business, not to consumers. This scaling consumer products is very difficult and very expensive. It just doesn’t fit our business model or investment thesis. Really, we want to see a B2B type of a product.
What are your considerations for the B2B market or industry that started biz competing [2:02]?
The growth of the industry is very important. We’d like to see at least 10% year to year growth of the industry itself, forecasted by reputable sources, not just the founder saying the industry is growing. Even at an innovative product in a shrinking industry can be a problem if the industry is not growing. So, we want to see a growing industry. For example, we’ve invested in companies in medical technology, cyber security, energy savings. These are all growing areas, but we’ve turned down opportunities in things like face to face education or traditional banking which we don’t see as growing industries. They are actually shrinking.
We also want to see a large addressable market, commonly called the TAM or Total Addressable Market. The Total Addressable Market really is the revenue if the company had 100% of all the potential business in that area. This of course never happens, but if a company has for example, a one billion total addressable market. And it can reasonably obtain about $100 million in revenue then it might be reasonable, because that’s [3:11] 10% of the total, that could be reasonable expectations. If however, the Total Addressable Market is $100 million, they’ll never obtain $100 million in revenue, because they can’t get 100% of the market.
So, it’s really important to look at that Total Addressable Market. It’s an important metric since, we want to see a reasonable path for a company to obtain $100 million in revenue, in our investments. It’s not really valid to say you get 10% of the addressable market without the details.
An important part of getting in that market is the sales plan which you mentioned as being important. Talk about the sales plan component of your analysis.
Sure, this flows from the Total Addressable Market we just discussed. It’s not sufficient to say, “We’re going to get half of percent of all the people in China to use our products. So, we’re going to have $1 billion in revenue. The question is, how are you going to do that? There needs to be built up from the bottom, not a percent from the top down. The assumptions made and verified as reasonable that we need to look at. We looked at the detailed calculations, spreadsheet projections.
Ideally, a spreadsheet should have assumptions that are built in, that can be changed to gauge the reasonableness of the projections so, we can simulate. Basically, change some factors and see what the bottom result would be. How that would change revenue if instead of 5% closing rate on something, it’s 4%. How did that change the bottom line? It’s a lot of work to build those kinds of spreadsheets, but really, it’s essential for us to properly evaluate sales forecast.
We had one submittal one time that a lady said she was going to have $3 billion in revenue in the third year. I said, “Well, how did you get that?” and she said, “Well, I’m going to have $100 million customers.” I said, “That’s great. How did you get that?” she said, “That’s how many my competitor has. And my product will be better than theirs. So, I’m going to have just as many customers.” Again, the assumptions have to be reasonable. And they have to be from the bottom up, not from the top down.
At least, some of this gained market shares is often going to come from one P1 away somebody else. So, I’m guessing competition plays a pretty large role in your analysis.
Absolutely, competition and valuation are probably the two biggest factors that we consider in making an investment. It’s also the area that often gets the least amount of attention from founders. Believe it or not, it’s really surprising. We’ll do a Google search after seeing a presentation or a submittal. And find all kinds of competition never even mentioned or not even known to the entrepreneur. We hear things like, “We’re going to be the first to market,” or, “We have no direct competitors.” Then we might do a Google search and we find companies already doing the exact same thing. It’s really actually pretty stunning how often that happens.
In one instance, we had a submittal where a company claimed the first to market for a software platform that they were developing. I put on search terms in Google, and found one of those software evaluation sites that had 47 software platforms that they evaluated. They were directly or closely related to the one we were evaluating. They were claiming they were going to be first to market. So, I approached the entrepreneur and I said, “What about these companies?” he said, “Well, they’re probably not doing the exact same thing we’re doing.” But again, he didn’t really know, and he never really looked at them. It’s surprising how often that happens, but it does happen.
At the seed stage, you mentioned MVP. Where does traction play into that? How much traction are you looking to see, and how important is that for SeedFunders?
I would say, traction is less important to us than most other angel groups. As I said before, we invest in pre-revenue technology. Obviously, revenue is not a factor in traction and what we look for. Most other investment organizations require not only revenue, but year to year growth in revenue. But for us at SeedFunders that’s not as important. There are however, other ways that we measure traction. One, which I mentioned before is the MVP – Minimum Viable Product. That shows progress. It’s not traction in its normal sense, because it’s not been out and gotten customers, but it is some traction. It allows the startup to get customer validation. That’s traction that can be looked at. They can do beta testing. The results we can analyze. So, that is some form of traction.
We also look at strategic partnerships as a form of traction. Do they have industry people that have partnered with them to develop their product or to help them promote their product? Other forms of traction we consider are letters of intent, letters of interest, pre-orders. These are all forms of traction that a company can have, without actually having any revenue at the point. Finally, grants if a government entity is granting a startup some funding, that’s a form of traction. If they have an interest in what the company is doing, that will be an interest to us as a form of evaluating traction a company has.
So, patterns, trademarks, copyrights where does intellectual play as a factor for SeedFunders?
Again, with SeedFunders, that’s not really a big area that we look at. We do look at it. But for example, if we invest – which we have – in a company with a patent, that it has been granted but they have no revenue, it still becomes very difficult for that company to defend the patent against large companies, with lots of lawyers who want to violate the patent. So, even though they have assigned an issued patent, it’s really still questionable whether that’s going to be enforceable or protectable. The patent does have value. It’s part of our consideration in evaluating a company, but it’s not as important as other investment groups who really want to see that the patent have revenue-generating, it’s implementing their patents, and have established it as a critical part of their business.
For SeedFunders that’s less important. In some sense it does create a barrier to entry. So, others can’t do what the patent protects, but again, violations are common and they’re hard to or even impossible to enforce. In a lot of cases, it might be more feasible for a startup to license the technology to larger, bigger firms that are going to be intent on violating the patent anyway. So, those are all things we do look at.
And you ask, when people come and seek funding, they’re going to be bringing financial projections to you. Are those, with regards to realism and accuracy just typically 98% correct, 99% correct?
Sometimes they are 98% incorrect. Sometimes, they are good and other times they are really pretty crazy. Like the one I mentioned before, with $3 billion in revenue in the third year. They are however, very important in our analysis. Most of all, we look for reasonableness. Because the company doesn’t have any revenue, we rely on the projections. We’re looking at the reasonableness. How reasonable are the assumptions? Can they be validated? Are the industry metrics valid? Are the costs realistic? Do they scale with revenue?
The two really most common mistakes we see in financial projections for startups. One, the revenue takes off like a rocket. This is often called a hockey stick, and expenses remain flat or slightly increasing. Therefore, the company’s going to make lots of money, because they aren’t going to spend a lot of money, but increase revenue tremendously. These startups often think revenue will increase as they gain traction, but sales and marketing costs won’t increase.
It’s common knowledge though – among investors anyway – that for a SAAS or software company, sales and marketing costs are 50% of revenue, yes, 50% even sales force. Sales and marketing costs are 50% of revenue. We often see entrepreneurs they say, “But I have a SAAS system. So, it’s going to just generate revenue without a lot of sales and marketing.” We never see that from startups in their financial projections. They basically think that they’re not going to spend 50% of their sales and marketing to generate revenue, it’s just going to magically appear.
Mm wow. So, what are some other mistakes that startups make in financial projections?
We often see profit as an unreasonable or unobtainable percentage of revenue. We’ve seen numbers like 70% profit. I’ll tell them, “Nobody makes a 70% profit.” Then they’ll revise their projections. Then I say, “Nobody makes 50% profits. It just doesn’t happen. You’re not going to be the first company ever to make 50 to 70% profit.” It mostly goes back to what I just said about costs for sales and marketing. Entrepreneurs tell me they’re going to generate say $50 million in revenue. And I look at their sales and marketing and it’s $5 million for sales and marketing.
Five million in sales and marketing may sound like a lot to a startup, but stats show that it will generate about $10 million in revenue. If a company is saying, “I’m going to spend $5 million and generate $50 million, that $40 million basically is coming as a profit with no related expense. That’s just not right. That’s how they get a forecast of 70% profit, instead of what would really be a 15% profit, if they put enough money into the sales and revenue. If they’re going to generate $50 million in revenue, they’re going to probably need about $25 million in sales and marketing. Then the revenue and profit projections will be more reasonable.
And we’ve talked about valuation I think a couple of weeks ago. Let’s bring that back through this lens. How important is that to SeedFunders as one of these factors?
As I said, along with competition I think valuation is the most important factor for us in considering an investment. When we talked about valuations in a previous podcast, I said there were two or about 10 methods that would give reasonable results. As I pointed out then, we need a potential 10x return in every deal, since about half of them are going to fail. We won’t even get return of our capital. So, if the entrepreneur insists on a valuation that will not yield that type of return, then we just have to walk away.
Unfortunately, many times these unreasonable valuations come from the fact that friends and family have invested at that valuation. We just recently had one where the valuation was set on the fact that previous investors had invested a certain valuation. Now, at some point later there was more work done. So, the company obviously was worth double what the previous investors invested at.
We look at what the company is worth today, not really what previous investors invested at, because that could be totally unreasonable. It gives a founder just unreasonable expectations when a professional investor comes around, insisting that the valuation agreed upon by friends and family or other investors who may not really know what a company is worth, sets the value for the deal that SeedFunders would come in on. That has really killed many deals for promising startups.
In our modern distributed workforce world, where does geography stand with SeedFunders? How important is that?
It is very important to us since our investment thesis is to fund companies in Florida or are willing to relocate or open an office in Florida. It’s not as important to other investment entities however who invest nationally or even internationally. But for us, it’s something all our investments consider because we need to see how the company fits into the investment returns in Florida. Our investment thesis is Florida-specific. Factors we all consider though include travel time, cost of living, access to markets, currency exchange, business clientele, taxes. Those things are really all factors in geography. And play a part for any investment analysis that anyone is doing.
Virtual meetings though – as you said – have recently made location less of an issue. As I said in a previous podcast, Florida is benefitting as companies are no longer required to be in Silicon Valley if an investor there has funded them and companies are moving to Florida. So, again that’s good for us. It’s good for SeedFunders to see these companies and geography is very important in our analysis.
Dave, this episode could go on forever unless we have an exit plan. How important is an exit plan?
We do need to be assured that there is an exit plan. Why is that important? Before making investment, we need to be sure that our goals are in line with the founder’s goals. As I said, we need to see a potential 10x return. It has to be in a three to five-year time frame to meet our financial goals. If a founder has different goals, that could be a reason we would pass on the opportunity. Basically, we need to see a way to get our capital back in a certain timeframe. We ask this question in our submittal process. One founder I saw wrote actually, in capital letters, “There is no exit.” And basically said, “I want to be like Jeff Bezoz and run this company for life.” Obviously, there was no investment either.
All right, I’ll activate our exit plan with any final thoughts.
No, I think you’re right. This is a good time for us to exit. Thanks Joe.