Investment Criteria

This post wasn’t planned, but I received many questions & comments following my last post. On Friday, I heard a pitch from a startup. I thought they would help me illustrate the themes I referred to in my previous post and another important theme I didn’t mention – focus! As you read, try to think about the thought process and taking this case study to a higher level.

In essence, the company is a Q&A platform similar to Yahoo Answers, Quora or JustAnswer.com. They have a sophisticated algorithm that mines and classifies questions, then forwards them to the relevant experts for answers. The company has been in beta for the last 9 months and has a talented team that includes AI and NLP experts, and a CEO who started a number of companies, some were more successful than others. The team is backed by a strong technical advisory board.

As they made their pitch, I noted 4 key assumptions:

1. The need – Consumers are not satisfied with current Q&A solutions in terms of time and/or quality.
2. The technology – They developed an algorithm that can accurately classify questions and match them to the right experts for a fast and accurate answer.
3. GTM – Viral – The company claims that the service has a viral element and people would share with friends, leading to a >1 virality multiple.
4. Monetization – Lead generation of products or services (e.g. books) sold by these experts.

Given these assumptions, I expected the team to validate at least 2 of the assumptions and present preliminary results in their presentation:

1. Benchmarks with regard to the time and accuracy of current solutions. How big is the problem? A time for answer of 5 minutes with a 80% accuracy rate is very different than an answer time of 20 hours with 50% accuracy rate. As an investor, I want to make sure the team validates the problem and its magnitude.
2. Stats measuring current accuracy. Post a question on the platform and across some alternative solutions and compare time, accuracy, or even basic classification.
3. The company’s entire GTM depends on its viral affect and yet not a single stat on that.
4. How many affiliation links were clicked per answer (then add conversion rate and test your revenue assumptions). Is conversion rate high enough to justify a lead-gen based model vs. existing business models ?

The reason companies go beta is to test assumptions, get early benchmarks or key performance indicators, and improve KPIs as they move forward.

Nine months of work and learning and not a single data point on their pitch (~25 slides). Instead the company (with 1K users) discussed the use of funds to expand globally and enable other monetization methods. Before replicating growth into other countries you want to make sure you have the right formula in a single country. Instead of applying other monetization methods, focus on one and make sure you get this right (or change to another one if this one fails).

In summary, let’s step back for a second to convey two themes:

1. Think through your major assumptions and make sure you prove/dis-prove them early on. Proving some of the assumptions reduces risk.
2. Make sure you focus on what’s important. As a small team you can only address a small number of issues: A single market segment, a single monetization method, one or two distribution channels etc. Make sure you get them right before you take a stab at additional sectors, distribution channels etc. Loosing focus would reduce your learning curve and would be a warning sign to investors.

Two theories guide me in an early-stage investment:

1. The notion that most business plans will change once assumptions “meet the market”. Given that I rarely read business plans or care to see one. I’ve shared my thoughts about business plans here.
2. The notion that an early stage startup is a hypothesis with many assumptions. Therefore, the risk is the ratio between the assumptions that were validated and the ones that were not validated yet.

Given that, the 6 most important elements I look at when assessing an investment in an early stage startup are:

The team – Is the team competent, are they focused on vision or execution, how analytical are they when it comes to product/customers, how well do they know their customers and competitors and how receptive are they to feedback. The process they went through so far is, what I found to be, a good indication of the future and so I spend a fair amount of time listening to their story and how the idea evolved. I also tend to assess what milestones they met so far (partnerships, number of customers etc.).

Barriers/defensibility – How easy would it be for someone to replicate the idea. Have they created a barrier to entry or do they have a proprietary technology/data that is valuable enough, even if their initial business model fails. A good example would be a company I saw a while ago named Centzy. The founders found a way to get accurate pricing data for local businesses that was dramatically cheaper than current methods. Such data is most valuable to companies like Yelp, Google and others and so I was confident they’ll find a way to monetize that value.

Scale – Some would call that the viral coefficient. Can the method used to acquire the first customer be used to scale and acquire many customers. Is it scalable. Can it be replicated.

The product – I never know what might fail and I don’t think anyone can. I never consider myself the typical customer, for good and bad. I only assess the product to the extent of whether it’s a vitamin or a pain killer. Does it solve a real problem or it is just a nice to have product. I tend to shy away from products which I consider features vs. standalone products.

Analytics – I tend to ask the founders for the 2-3 metrics they watch to assess how they are doing. Cost of acquisition, MAU, life time value would be a good start if you are an online consumer startup. I’m a big believer in numbers since numbers are hard to argue with.

Market – I know that many VCs are looking for startups in big and growing markets, assuming the startup will take a portion of that growth. That, in my view, led to so many group buying/Social networks/photo sharing/content discovery startups. I just want to know the company doesn’t target a 90% market share to reach $20M in revenues.

Some final suggestions:

-          Be respectful in your communication style: send follow-up emails and reply in a timely manner.

-          Have a compelling Executive summary that is interesting yet simple. Think about it as a brochure and use it to make your startup shine.

-          Know your investor. Read about his background, previous investments, blog posts and tweets etc. Be prepared.

-          Know your competition. “We have no competition” eliminates your chances to get funding. Not knowing about one is likely to have a similar effect.

-          Don’t send a LinkedIn invite before we meet. I don’t know you and therefore I’m not likely to respond (you can’t imagine how many entrepreneurs do that).

- Reference from a trusted source is always advised. (Thanks for that Thorsten !)

The 2011 Bubble ?

2011 was probably the first year the word “bubble” was mentioned so many times since 2000. Just as the year ends I think it is worthwhile to step back for a second and re-assess if we are headed for another bubble.

Short answer  - no.

Long answer: Probably not yet but that is thanks to macro economic conditions (high unemployment rate across the world, European countries at a default risk etc.) and investors who still recall the dotcom era. As we head into 2012, however, venture capitalist Paul Santinelli says we’ll see the end of that bubble, the end of easy money for companies with the supposed next killer app, and an end to “frothy” angel investments climate.

So why write about it?

If you compare the IPO landscape in the last 12 months with the IPO landscape back in the dotcom era your will find many concerning similarities.

March 9^th, 2000:

-          378 technology companies went public, leading to a total market cap of $1.5 trillion over accumulated revenue of $40 billion.  87% of these 378 companies had never seen a profitable quarter by the time they went public.

-          Carsdirect.com raised $280M in a round C financing

-          1500 biotech companies we established out of Harvard, MIT, Stanford and other universities. 350 of them went public with only 10 to 15 of them expecting to be profitable by 2001.

-          3600 funding deals by the end of 1999.

-          800 incubators operated in the US (150 incubators operated in the UK).

December 22^nd, 2000:

-          The market cap for these 378 companies was worth ~$375B. A 75% decline ! 130 companies actually closed their operations and 60,000 employees were fired from 600 companies.

December 22^nd, 2011:

-          Zillow went public without a single profitable quarter, a $6.7M annual loss and, based on their S-1, a decent chance that they won’t be for a while. Similarly, HomeAway went public with a $6.6M quarterly loss. Groupon IPO’ed with an annual loss of over $400M. ServiceSource went public with a $1.1M net loss in Q2/11. Some of the other recent IPOs were also not profitable or marginally profitable before they IPO’ed.

-          DropBox raised $250M of round B at a $4B validation

-          By the end of the year somewhere between 3500 to 4000 funding deals are expected.

-          The estimated number of incubators in the US stands at 1500 !! My fellow European colleagues also mention a surge of incubators.

And finally some stats about the return of recent IPOs Year-to-date:

-          Zynga –  -60%

-          FriendFinder Networks (FFN) – -94%

-          Mission New Energy Limited (MNEL) – -94%

-          Sequans Communications S.A. (SQNS) – -77%

-          Renren (RENN) – -75%

-          Trunkbow International (TBOW) – -63%

-          Tudou Holdings (TUDO) – -62%

-          Demand Media (DMD) – -59%

A bubble burst or not ? I’ll let you decide.

Sources:

“The worst-performing US IPOs” – Forbes December,28^th 2011

“The Internet Bubble” – Anthony B. Perkins  and Michael C. Perkins

Can Silicon Valley be replicated? Reid Hoffman gave his opinion earlier this week. Let me share my humble opinion.

Silicon Valley can be adapted in some countries.

A healthy entrepreneurial ecosystem is dependent on a number of ingredients. While all of them are summarized at the bottom, let me touch upon some of them:

Human capital – The ecosystem cannot exist without a basic element – entrepreneurs. The supply of entrepreneurs is dependent on two main ingredients:

• Universities – In many countries startups emerged either from academic researches or lab experiments (Stanford Research Institute, known as SRI, was established to commercialize some of Stanford’s research) or by a group of students who studies together and teamed up to build a new venture (sounds like the story of Facebook, doesn’t it?). The demographic of the crowd and their day-to-day activities serves as a fertile ground for innovation & entrepreneurship.

Stanford , which established an incubator named StartX, IE business school’s (Spain) Venture Lab and the Tel Aviv University’s    Startau are just some examples of university led initiatives to support student led startups. These incubators work closely with the industry to drive practical innovation.

Germany, in the late 90s, recognized the role of universities in the ecosystem and tried to drive entrepreneurship through   universities but the lack of industry involvement led them to focus on research vs. development and the initiative failed.

• Culture – Some cultures express zero tolerance to failure. For others failure means you’re closer to success. Similarly, in some cultures being an entrepreneur means being unemployed. In others, being an entrepreneur means being an Innovator. In Taiwan, for example, the dream of a student who just graduated from university is to work for HTC so he can support himself and leave his parents’ house. At Stanford, a significant portion of the graduates, start their own companies.

Culture has been the number one challenge for most countries. Most cultures are risk adverse but a culture can be adjusted in certain groups with the right incentives and a long term view.

Government support – The government plays a key role in driving the change by incentivizing entrepreneurs, making it easy for them to start companies, establishing funds and STAYING AWAY ! Give entrepreneurs little funding so they can work on their venture and sustain for a few months, offer tax incentives and cheap incorporation, support the establishment of the other building blocks (e.g investors) and STAY AWAY ! In countries where unprofessional government officials started making investment decisions and asking entrepreneurs to send status reports every other week instead of building a company, the ecosystem didn’t stand a chance and failed. Put the capital in the right hands and let it go. Israel & Chile are two examples of how limited government involvement led to the establishment of a healthy ecosystem (more about that on the next post).

Investment vehicles – Very few startups can scale with no funding. The entire model is dependent on investors taking some risk and putting capital in exchange for equity or debt. The ecosystem needs early stage investors (angels, incubators and micro-VCs) and most likely late stage investors (Growth stage VCs and banks). The EU has identified this missing element and has been co-investing in VC funds across Europe (with other pieces of the ecosystem are still missing).

Markets– I’ve outlined two critical elements under the title “markets”:

• Demand/customers – My experience led me to the conclusion that a company needs to be located where its customers are (or competitors/partners) to best understand their needs and decision process. It is easier to build a fashion company in Paris, a car company in Detroit or Aichi, Japan and a consumer electronics company in Korea.

Currently most of the global entrepreneurship landscape is focused around online consumer and e-commerce/social networks in particular, leading to disappointing results in many countries. Very few countries have comparative advantages compared to the Silicon Valley.  Sectors such as the financial industry, public sector, fashion, food and enterprise are all waiting for innovation. Some geographies have large incumbents, experienced talent and a pool of customers that can better support innovation in those sectors vs. online consumer.

A big challenge for every startup is getting its first customer. A risk adverse late adopters market can “kill” many good startups. On the other hand, a pool of early adopters can quickly lead a startup to find the right product-market fit.

• Exit/liquidation – Investors, at the end of the cycle, are expecting a return on their investment, either through an IPO or an acquisition. Regulation, posing challenges for companies who wish to IPO, lead to concerns about the ability to liquidate and discourages entrepreneurs and investors.

Support system & Infrastructure – Startups need law firms who can incorporate their company, accountants who can support their financial operations (while deferring some of the fees), conferences where they can either present or learn about the market, co-working space (and infrastructure) where they can meet like minded people to work with etc.

I haven’t done a deep research on that, but I bet that a large portion of the entrepreneurs around the world and in the Silicon Valley in Particular are foreigners. I did see a research stating that 25% of the public tech companies in the US were started by immigrants. The UK identified this critical element and established a startup visa. The US is still struggling with that.

I will finalize with a final element that many emerging ecosystems still miss:

Global mindset – Very few markets are large enough (China, India or the US mind be such). Israel was very successful in building its ecosystem mainly since the domestic market is too small and entrepreneurs had to think globally from day one. That means visiting other countries, establish relationship with potential partners early on, and build a product that meets global market regulation and industry standards. Let me leave you with that thought: What is the likelihood of a non-English speaking entrepreneur selling or taking his company public (they are not zero…true).

In summary, very few countries have been successful in building an ecosystem, mainly since they tried to replicate the Silicon Valley, instead of identifying the missing elements, their core strengths and figure out the right way to bridge the gaps.

The elements requires to establish a healthy ecosystem for startups

Startup number 59 gets on stage. 20% of the audience is on their smartphones. 30% of the audience is reading emails or reviewing their Facebook. The presenter starts “We are a mobile/social/universal content discovery/shopping/ marketing company…..” At that stage I’m thinking “wasn’t startup 58/57/56 also a mobile/social/universal…” and together with another 20% of the audience – stop paying attention.

I tend to have a good memory but I don’t remember most of the companies who presented at DEMO (well actually I might remember what they are doing but not their name nor any other details). I will remember VisualBee, who used their tool to build their presentation in real-time on stage, as they were pitching. I will remember Gumhoo, who made the audience laugh in the first 20 seconds, while presenting a problem most of us can easily relate to – shopping alone and looking for advice.

Why? Because these startups were unique.

The majority of the startups attending pitching events and conferences, like DEMO US, fail to clearly define the goal and their audience. The goal is not to present the product, how you use it, how cool the design is and its robust feature-set (which about 50% of the startups did). No one is going to write you a check for doing that nor will you be able to present all your features in a 5 minutes pitch. The goal is to GET ATTENTION ! Details? The relevant audience will approach you after your presentation for details, if you are successful enough in getting their attention. At that point they are likely to pay more attention and will engage in a more effective (two-way) discussion. Think about it: Your potential investor might be sitting in the audience reading his emails. Your goal is to shift his attention back!

If five startups pitch their product to a crowd, e.g., four teams with a great product but a standard presentation and one with an average product but a unique sharp presentation, it fair to assume that the average product superb presentation startup will get the most attention.

Your first 30 seconds will make a huge difference to the rest of the presentation. Mention an experience they can relate to, make them laugh or just surprise the audience, and you are likely to have their attention for a fair number of minutes. They are expecting additional surprises and therefore are likely to listen carefully to every word you say, not to miss your next joke/surprise.

30% of the investment decision is based on the team. The product/design/business model is likely to change. An engaging and inspiring presenter is likely to get attention even if the product is average.

To finish up this post, a quick disclaimer: this approach is primarily relevant when it is not a one-on-one pitch. People tend to pay more attention in one-on-one meetings. Having said that, a unique way of grabbing someone’s attention is always useful.

Finally  – always think about your audience.

To those who presented DEMO or plan to present at DEMO or similar conferences – next week I will publish lessons learned from the startup presentations. Stay tuned. You would want to read that !

Emerging sectors in the startup landscape

-          Enterprise consumerization – With mobility (smartphones, tablets etc.) penetrating enterprises and online consumer practices being replicated to workplaces, dashboards, social network & collaboration and online marketing tools are on fire. Asana and Whodini are examples of social networks and collaboration tools for enterprises. I’ve also seen numerous startups this week, trying to make sense of all the data enterprises have and present that in nice & clean dashboards. Moprise, a Flipboard for enterprise, is a solid representative in that sector.

-          Hiring & job seeking – with unemployment rate exceeding 9% in the US and hundreds of candidates competing for every open position, many startups are trying to address the need for enterprises to quickly screen candidates and for candidates to standout. Examples include JobOn, an interactive platform that allows candidates to submit short videos, addressing employer’s questions, and Unrabble, which allows to quickly & automatically screen candidates.

-          Content discovery – This sector includes companies around filtering and discovering relevant content or activities online. Close to ten companies presented apps recommending content (e.g Pinevio), events (e.g uTemporis,Conferize)  wine (e.g TasteJive, WinoBot) & other activities (e.g Lifecrowd).

-          Small business’ marketing & optimization tools – With so many small businesses out there, many companies are offering simple tools for local business owners to market their services online, analyze their online presence and offer their services at discounts. Daily deals, Twitter analytics, lead generation and loyalty programs are the most common subsets of that. Schedulicity, for example, enables small businesses like hair-stylists and saloons the use of social media to advertise open slots in the calendar, in order to minimize free timeslots and maximize booking.

-          Data mining – This sector has been in the spot lights for a while now. With Hadoop and other tools to analyze big data sets, many startups are trying to find ways to drive analytics from those data arrays. VoyUrl, for example, is trying to analyze online users browsing behavior and recommend new content based on tens of thousands of browsing entries gathered.

-          Video & picture editing & publishing – with so many videos available online, discovery serves one need. Quick editing is another need.  Stroome, for example, excited the DEMO audience with a quick tool to edit and mix different clips into a single video. DragOnTape & WeVideo offer similar services as well.

-          Last but not least, a number of companies presented different services involving augmented reality. Aurasma wowed the audience by turning an old newspaper into a 3D interactive up-to-date newspaper, and a billboard into a shining 3D videoclip. Fitting Reality used Kinect to try on different dresses in seconds. The audience was fascinated by the experience and cheered these companies, but my take is that the market is still relatively immature and we are still missing the business models and the right use cases to drive AR into the early adopters.

We still see some daily deals type of companies but it feels like most consumers are not interested in another deal aggregator.

Many Startups are Premature & lack technological and/or To-Go-Market

Unfortunately a large percentage of the companies, who presented at DEMO, launched their products too early. Some didn’t have a working product and so they spent time overwhelming the audience, getting them to buy into the experience and then….you discover they are 1-2 months away from a GA product. With so many services launching every day, I doubt if most people will remember them in 1-2 days ! Consumers today have a short attention and a tendency to fulfill their needs here and now.

Some other common flaws, you might want to avoid:

-          No social proof or validation – It felt like a number of the companies decided to launch their product at DEMO without much validation, A/B testing or any sort of user testing. If you are presenting a new product in front of hundreds of consumers, VCs & reporters, you want to make sure you had enough pivoting based on user feedback.

-          Changing consumer behavior – Some of the companies were relying on changing consumer behavior, in order to adopt their service. Such examples include adopting a new site, downloading  new software or using a new currency to buy goods. Changing consumers’ behavior is not trivial. Many companies have failed doing that (including Google & Apple). If you are trying to change consumer behavior, you better have a plan and some initial validation that it might actually work.

-          No Go-To-Market – An overwhelming number of the startups, didn’t have any Go-To-Market planning what-so-ever. A GTM plans, is a plan for how the company will scale and reach a sizeable amount of consumers. Going viral or even having a well connected co-founder is not a way to scale in most businesses. Focusing on a sub-segment, where your product/service brings the most value or sub-segments that, for some reason, are easier to tap into (a partnership with a large distribution channel, a targeted segment that uses a single channel etc.) are viable GTM plans.

-          Though this item is last it is probably the most common one – Many of the startups presented a nice feature,  that, if successful, can be replicated in a matter of days by the incumbents, but definitely not a product or a service. Again, we are overwhelmed by new apps and online services in every given day and we spend maybe a minute testing the ones that we think bring us true value. Anything that saves significant amounts of time or money, for example, is included in that category for most people. Without mentioning specific companies that launched at DEMO, another app that allows you to manipulate pictures or meet new people or even give you recommendations about products in a niche market, are nice features within Yelp or Facebook, but rarely survive as a standalone product. The barriers to replicating such features are low and, unless there is some technology behind it, would serve as a nice feature within an existing service.

A New Breeze

To finish this post, I would like to mention two sectors in which are starting to show some nice traction: Health and education. Zero2one presented Lumoback, an app that helps us keep our back health. MeMeTales, presented a tablet app that helps us drive our kids to read & enjoy books (and who wouldn’t pay a couple of bucks so his kids would love to read).

That’s all for today folks.

Next week I’ll talk some more about the presentation styles of some of the participants. Stay tuned !

In the US, the number of startups going through incubators annually is expected to reach 300 by the end of the year. The map below gives you a detailed glace at the leading incubators across the US and the number of companies funded by 2010 (source: The startup Factory by NESTA).

List of leading incubators in the US - 2010

So what is an incubator ?

An incubator is usually a short term program that helps entrepreneurs transform an idea into a working product or prototype (and hopefully a fundable company), while giving them resources such as mentorship, funding or access to investors. Why was I careful to use the word usually ? Many people might not be aware but there are different types of incubators:

Pre-seed Pre-idea incubators – These are programs that gather a bounce of talented entrepreneurs with complementary skills and let them identify and address a need. Such programs are very common in markets that lack significant deal flow such as Singapore & Hong Kong, but we have seen such programs in the US as well. IdeaLab and Innovation Endeavor’s Runway program are such examples. These programs are usually less structured and offer the entrepreneurs a base salary as they go through the program, in exchange for equity.

Classic incubators – Most incubators have a 10-13 weeks program, to which groups of 2-3 entrepreneurs apply (acceptance rate to the top incubators is around 2%). The focus of those incubators is on lean business plans what can be prototyped and validated quickly. Incubators offer a range of resources from office space to funding in exchange of equity (usually 5%-8%).

While most people, tend to think that the biggest value of an incubator is in the initial funding (~$12-$20K), the biggest value is in the mentorship and collaboration (which is the reason most incubators tend to select companies that work in adjacent markets). By working with serial entrepreneurs and other executives who are familiar with the target markets, and by engaging in discussions with other startups around common challenges, startups speed-up the learning curve dramatically. Starting a company is a tough journey and so sharing the load also increases their ability to sustain the journey.

The other challenge that most startups face is in getting in touch with investors and conveying their message in a clear and compelling way. Most investors listen to numerous pitches in a given day and don’t have the time to look beyond the communication style and messaging. Incubators provide access to investors through demo days and 1-on-1 meetings. They also work with the entrepreneurs on how to communicate the opportunity. The quality of the investors, though, ranges from one incubator to the other.

Having visited numerous co-working space, the energy & discussions seem to have a positive impact on startups, but top incubators such as Y-Combinator are actually not offering co-working space.

Most incubators are measured based on two factors: The number of companies that get follow-on investments and the financial returns (exits).

Accelerators – Accelerators, a subset of the classic incubators, target companies that have launched a product, but either their growth has stalled or are now trying to target a new market.  Many times these are companies still in search for a product-market fit. Plug&Play (PnP), might be considered such a place. Vodafone, recently launched Xone, an accelerator based in Redwood city, to target such companies, assuming they offer a strategic value to Vodafone.

What is the incentive for the mentors ?

Many mentors want to be associated with successful incubators. Some of them later join the board of the companies they really like. It also offers them a glance at where markets are heading. Many of the mentors are also angel investors and so incubators offer access to deal flow and enable the angel investor a chance to get to know the entrepreneurs before making an investment.

VC firms share a similar incentive to attend meetings at some of the incubators: Great access to deal flow and market insights.

Should I apply for an incubator?

If you are a first time entrepreneur, an incubator can be great for you. You should make sure that in 10-13 weeks you can actually launch a product and become fundable. That means:

-          You have the right team in place

-          You have been working on the idea for a while so you are not in the early stages of the learning curve (unless this is a pre-idea incubator)

-          Your product can be prototyped in a short period of time (Most medical devices & cleantech startups are not suitable)

Before applying to an incubator, think about the following:

-          What are you trying to achieve? Are you looking for access to investors or mentors ?

• If you are trying to get access to investors: How many investors attended the last demo day ? Did they fund other companies in your space ?
• If you are looking for mentors: Who are the mentors in the program and how knowledgeable are they with regards to your specific industry ? How accessible are they?

-          Make sure you talk to other alumni. That way you can filter through the marketing collateral.

Finally, aspects as hands-on/off approach and brand affiliation are also important in your decision to apply to one incubator or another.

Will we see more incubators emerging?

I tend to believe we will see more incubators emerging, but also many incubators shutting down. An incubator needs to fund enough companies in specific sectors to really know that sector and develop a track record, on the one hand, and have enough funds to sustain until they start to see some early exits, on the other hand. They should also have a market with enough alternatives for follow-on investments and eventually exits. Many incubators emerged, but didn’t have enough runway to sustain. Bootup Labs (Vancouver, BC) , DifferencEngine (UK) and OpenFund (Athens, Greece) are all incubators who had to shut down their activity after 1 or 2 rounds.

It will be interesting to follow the pre-seed pre-idea incubators. Most of them are still in early stages and so not enough data is available to assess their track record.

 Full Disclosure: The writer is a board member and mentor with a number of incubators.

In summary a company today can launch a product and get an initial validation with less than a $100,000 in cash. A fair number of companies will scale and turn profitable with a ~$5M round. Historically, companies raised ~$5M to develop and launch their product and a significantly higher round to scale.

A new Era in Fundraising

There has been an emergence of a shadow venture system over the past several years as angels have institutionalized, yesterday’s successful multi-millionaire entrepreneurs have become a legitimate capital market, and incubators have re-entered the funding formation process. In the later stages, a few traditional VCs are turning into mutual funds. Add secondary markets, and the world of investing has profoundly changed.

What does this mean for VC firms

Deal flow is the single most important element for a VC firm. The math is simple: More deal flow => higher quality investments => higher chances for high returns.

A couple of elements in today’s environment challenge the access to quality deal flow:

-          Early stage competition – Given that less funding is needed in the seed stage, angels (high net worth individuals), incubators & super angels are emerging as alternative sources of capital.

-          Early stage acquisitions – Many startups will never raise a VC round/Round A. Zappedy acquired by Groupon last month after a small seed round a couple of months ago. Groupon also acquired Grooper nine months after they raised a small friends & family round.

-          Late stage investments are competitive – The rounds for high quality deal flow (e.g companies that receive impressive traction early on) are becoming very competitive and VCs are required to be quick in their decision making.

To address the challenges, a number of VCs have reinvented themselves and changed their strategy.

-          Micro VCs – VC firms like First Round Capital, Union Square Ventures & Felicis Ventures have identified the transformation and raised smaller funds, focused on early stage investing. This is not a trivial change: Managing hundreds of investments in a given time or quickly making investment decisions (First Round Capital made 5 investments this month, according to CrunchBase) instead of waiting for the monthly partners meetings, requires a different operation model.

-          Internal deal flow generation – some VC firms have hired serial entrepreneurs as Entrepreneurs In Residence (EIR) and give them a small fund to explore different ideas. Greylock, for example, have 7 EIRs including Josh Silverman, Skype’s ex-CEO.

Finally,  many VC firms will not raise another fund and will discontinue their operations. The number of VC firms has been in decline since 2001 and I expect that to continue in the upcoming years. The transformation discussed has affected many VC firms, whose initial fund strategy did not match the current era.

Total VC since the late 90s

A final thought about the industry moving forward: This is little differentiation between VC firms today. Most of them focus on online consumer & mobile (some cleantech or cloud/SaaS). I expect VC firms to try and develop a differentiator that will help them emerge as leaders in their niche (by sector, expertise or geographies). Vinod Khosla’s venture is a good example of that.

When will that happen ? We’ll have to wait & see.

Starting a company is like getting married. You are actually likely to spend more time with your co-founder than with your wife in certain times. You are likely to experience ups and downs, debates and difference of opinion. As with meeting your future wife the two best ways to find your “sole-mate” are:

-          Getting “married” to someone you’ve known for a long time – You either worked with that person in a previous company or you’ve been close friends for years. You are familiar with his working habits, strengths and weaknesses and you know how to work around them. You share common interests and you are not likely to be surprised by things you didn’t know previously (and hopefully not by things you decided to ignore).

-          Getting “married” to someone you got introduced to by a close friend – If you trust your friend to know your “preferences” and know what is likely to work for you, you are likely to go on a “date” that might lead to a “marriage”. Your friend can tell you all about that person’s record and vouch for him/her.

In both cases, the partnership is based on a solid ground that extends beyond the current idea and so it is likely to lead to succeed, even if the current startup fails.

If you have not found a match within your close circles then you are likely to go on to “singles meetups” and “online dating”.

-          Identify the skill-sets you are looking for and the companies these potential co-founders are likely to work for. Use LinkedIn to find past employees who are looking for new challenges or current employees who are about to leave. Today many people have blogs, through which you can find a way to get in touch with them. Through social networks you can get an introduction and even a recommendation.

-          Join online forums where subject experts are likely to chat. When I was looking for a recommendation engine architect, I joined a number of technical forums and watched closely the participants and the quality of their answers. After a couple of weeks I got in touch with the ones I was most impressed by.

-          Join offline forums – If you are looking for a technical co-founder, there are hacktons and develop conferences, where you are likely to find relevant engineers. If you are looking for a more specific skill-set, find the relevant forums where such engineers hangout (this can be a bar close to some company’s headquarter for example) and hangout there. There are many events, targeting specific audiences based on skills, background or interests.

Figure out where your potential co-founder is likely to hangout. Later on, you will have to do the same with your customers

Regardless to where you met your co-founder, take the time to do your due diligence and explore the personal and professional fit. I often come across an entrepreneur who partnered with a co-founder after one or two meetings and a couple of weeks down the road things get challenging and the co-founder decides to quit. Such an event usually has critical implications on the company’s survival rate or at least on their time-to-market and financial plans.

Good luck !

p.s feel free to comment with any other experiences you had in finding a co-founder.

I’m not a one liner type of guy as Andy, but I agree that product-market alignment is one of the most important elements for a startup, probably together with the quality of the management team.

Product-market alignment is key to established companies as well: That is a major reason why Microsoft acquired Skype, Why Nokia’s recent mobile phones failed and why the iPhone and iPad are dominating the mobile market.

The single customer test
Understanding the market and finding social proofs to their ideas is the thing I find most of the companies I work with in need. You come up with an idea. You know you would definitely use it and you are sure millions of others will do so as well, right ? So did the founders of Blippy and Bling Nation.
When coming up with an idea for a new product, I never consider myself the typical customer and whether I use something or not is not the right indication.

Many companies ask about future experience or a possible intent. I can’t remember how many surveys I saw where the questions started with “if you were….”

Never ask about hypothetical experiences or about a possible intent. We all know that purchasing decisions are rarely rational. We also know that there is a gap between intent and the actual action.
So what is an good indicator ? The past.

Past as the best indicator for the future
Let me explain: If someone has purchased a similar product or used a certain service that offers a similar value to your product or solves a similar problem – that is the best indication to the perceived value and the pricing model.
By understanding the decision process and the motivation for a customer to buy a similar product, you can learn much more.

Think about the different answers one would get by asking the two following questions:

Would you be interested in buying a Porsche ? (“sure I would”)

What car did you buy ? Why ? (“I bought a 2005 Honda cause it is cheap to maintain”)

The Yelp/e-Lance for luxury cars
I’m currently working with a company that is aiming to connect luxury car owners with qualified technicians. They were struggling with the business model and were thinking of charging the car owners for connecting them with the technicians. I thought their business concept is similar to Yelp or oDesk/e-Lance. E-Lance, a site connecting freelancers with project opportunities, taught us that business owners are willing to pay publishers who help them generate additional business vs. asking a customer to bear an additional cost.
Moreover, I also suggested they explore the channels luxury car owners currently use to tap into qualified technicians: Is it through personal recommendations ? Is it through business review sites ? (I used Yelp to find my last technician).

This implies a lot about the process customers go through and the experience the company needs to generate online to increase their chances to scale: Do they need to create a site that is tightly coupled with a social experience and where they can get a personal recommendation from a known person or can they rate and recommend technicians based on their own mechanism.

To summarize, product-market alignment is key and understanding customers through past experiences is key to helping companies get the right product-market fit.