If you build it, they may come - but will they pay?
I was reviewing a business plan/slide deck last week for a consumer web/technology entrepreneur who is beginning conversations with investors regarding a Series A round of funding. The founder has made amazing progress to date, building a scalable technology platform, several branded sites, and some notoriety in the space he’s attacking. When you get into the details and realize that the founder has done all this by himself in a true “bootstrapping/nights and weekends” manner, it’s even more impressive. There is a valuable infrastructure set up and the potential to scale with the help of invested capital.
As I worked through the plan and provided some feedback, I was struck by a familiar characteristic I’ve seen in countless companies started by technical founders – an inability to connect the dots between the “coolness” of the technology and the actual value that the technology has in the market.
Put a different way, the problem can be characterized by a simple question: “What you’re building looks really cool, but who is going to pay for it (and how much?)” It’s a question which is almost too simple, and yet is often not treated with the correct amount of rigor in the earliest stages of planning a venture.
First, a bit of theory. It’s a commonly held belief that companies are worth the “present value” of their future cash flows. This dynamic is often overlooked or misinterpreted when looking at companies that pursue venture capital. Since these companies can be very early in their life cycles (and even pre-revenue), it can be very difficult to predict future streams of cash flows. Often a VC will attempt to project possible exit multiples and probabilities based on industry dynamics. These dynamics are tied to a variety of variables, but almost always include some combination of revenue, EBITDA, free cash flow, etc. This provides a framework for justification of the VC’s given level of investment. It’s what allows the partnership to agree that a $1.5 million dollar early stage investment for 30% of the equity shares in a company is a good use of capital.
Implicit in all of the above is the understanding that at some point in time, the company will begin convincing a customer base to pay real, hard cash for their product or service. Most aspiring entrepreneurs focus on the type of revenue model they will employ – monthly subscription, enterprise license, transaction based, SaaS, price per widget, and ad supported are all examples on the technology side. Many founders are aware of the different types of models and even go through the motions of explaining the type of model their company will employ. Often this is coupled with a top down picture of the general market segment they’re attacking and the reason they’re sure to be successful.
The mistake that is often made is there is too much focus on “this is a billion dollar market” and not enough deep-rooted detail around “how and why will someone in the billion dollar market pay for what we’re offering.” (And this is without getting into the issue of market vs. addressable market which seems to bite many entrepreneurs and is surely a topic of another post).
I’m sensitive to the fact that projecting revenues is really hard for start-ups (believe me, as a banker I see tons and tons of financial projections per year and can usually count on one hand the number which accurately reflect actual performance at year end). It can be even more difficult to project for a nascent industry or one which is being attacked with a new technology or application. I’m not even suggesting that an entrepreneur has to know exactly how the company will make money or exactly how much someone will pay for a product or service. What I am saying is that fleshing out potential models and potential revenue streams is an absolute necessity when putting together your plan, especially when considering the idea of raising angel or venture capital.
I’ve found that going back to basics can be very helpful when doing this sort of analysis. Most likely the new venture is a constant source of conversation with your close friends, colleagues, lawyer, mentor or even your spouse/significant other. Try bouncing your revenue model ideas against these outside observers (it helps if this person is outside the nitty gritty of the start-up; even someone with little to no technical/industry expertise can be very valuable). Explain the revenue model and why you think potential customers will pay for your product or service. When you’re pressed to back up your claims, see if additional research provides some quantifiable bottoms-up data to support your thesis. Even better, go out and get some customers to pay you for your offering – there’s no greater market research than actually getting into the market and selling.
In the process of explaining your story (and answering the subsequent questions), you’ll uncover details that were either taken for granted, ignored, or were inevitable blind spots suffered by all entrepreneurial founders. Talking out your model in plain English requires a progression of thought which is very different than an Excel model put together to show a hockey stick growth curve that will satisfy investors. As you go through this process (preferably multiple times) you will find your start-up idea improved in multiple ways:
- You’re likely to understand the underlying dynamics of your potential business in much greater detail. Talking it out may lead to the creation of new products/features or the removal of ancillary ideas that don’t add incremental value.
- You get comfortable telling your story to outside observers. This will prove to be incredibly valuable as you pitch to potential investors. Sure, your friends and family network may not ask the hard questions that a VC will ask, but just getting comfortable with the story is half the battle.
- You may realize new and important details around the potential size and scope of your venture. Are you starting a business with potential for $2MM in annual revenues, $10MM, or $100MM? The answer has an enormous impact on the type of capital you really need.
In short, if you build it, they may come. And even if they come, they may or may not be willing to pay for the “it” that you’re building. But there are several long term rewards for applying some very simple rigor in the early stages of business planning when it comes to hashing out your business model.
