Market
Notice I’ve been careful to talk
about whether a startup is worth investing in, rather than whether it’s going
to succeed. No one knows whether a startup is going to succeed. And it’s a good
thing for investors that this is so, because if you could know in advance
whether a startup would succeed, the stock price would already be the future
price, and there would be no room for investors to make money. Startup
investors know that every investment is a bet, and against pretty long odds.
So to prove you’re worth
investing in, you don’t have to prove you’re going to succeed, just that you’re
a sufficiently good bet. What makes a startup a sufficiently good bet? In
addition to formidable founders, you need a plausible path to owning a big
piece of a big market. Founders think of startups as ideas, but investors think
of them as markets. If there are x number of customers who’d pay an average of
$y per year for what you’re making, then the total addressable market, or TAM,
of your company is $xy. Investors don’t expect you to collect all that money,
but it’s an upper bound on how big you can get.
Your target market has to be big,
and it also has to be capturable by you. But the market doesn’t have to be big
yet, nor do you necessarily have to be in it yet. Indeed, it’s often better to
start in a small market that will either turn into a big one or from which you
can move into a big one. There just has to be some plausible sequence of hops
that leads to dominating a big market a few years down the line.
The standard of plausibility
varies dramatically depending on the age of the startup. A three month old
company at Demo Day only needs to be a promising experiment that’s worth
funding to see how it turns out. Whereas a two year old company raising a
series A round needs to be able to show the experiment worked. [8]
But every company that gets
really big is “lucky” in the sense that their growth is due mostly to some
external wave they’re riding, so to make a convincing case for becoming huge,
you have to identify some specific trend you’ll benefit from. Usually you can
find this by asking “why now?” If this is such a great idea, why hasn’t someone
else already done it? Ideally the answer is that it only recently became a good
idea, because something changed, and no one else has noticed yet.
Microsoft for example was not
going to grow huge selling Basic interpreters. But by starting there they were
perfectly poised to expand up the stack of microcomputer software as
microcomputers grew powerful enough to support one. And microcomputers turned
out to be a really huge wave, bigger than even the most optimistic observers
would have predicted in 1975.
But while Microsoft did really
well and there is thus a temptation to think they would have seemed a great bet
a few months in, they probably didn’t. Good, but not great. No company, however
successful, ever looks more than a pretty good bet a few months in.
Microcomputers turned out to be a big deal, and Microsoft both executed well
and got lucky. But it was by no means obvious that this was how things would
play out. Plenty of companies seem as good a bet a few months in. I don’t know
about startups in general, but at least half the startups we fund could make as
good a case as Microsoft could have for being on a path to dominating a large
market. And who can reasonably expect more of a startup than that?
Rejection
If you can make as good a case as
Microsoft could have, will you convince investors? Not always. A lot of VCs
would have rejected Microsoft. [9] Certainly some rejected Google. And getting
rejected will put you in a slightly awkward position, because as you’ll see
when you start fundraising, the most common question you’ll get from investors
will be “who else is investing?” What do you say if you’ve been fundraising for
a while and no one has committed yet? [10]
The people who are really good at
acting formidable often solve this problem by giving investors the impression
that while no investors have committed yet, several are about to. This is
arguably a permissible tactic. It’s slightly dickish of investors to care more
about who else is investing than any other aspect of your startup, and
misleading them about how far along you are with other investors seems the
complementary countermove. It’s arguably an instance of scamming a scammer. But
I don’t recommend this approach to most founders, because most founders wouldn’t
be able to carry it off. This is the single most common lie told to investors,
and you have to be really good at lying to tell members of some profession the
most common lie they’re told.
If you’re not a master of
negotiation (and perhaps even if you are) the best solution is to tackle the
problem head-on, and to explain why investors have turned you down and why they’re
mistaken. If you know you’re on the right track, then you also know why
investors were wrong to reject you. Experienced investors are well aware that
the best ideas are also the scariest. They all know about the VCs who rejected
Google. If instead of seeming evasive and ashamed about having been turned down
(and thereby implicitly agreeing with the verdict) you talk candidly about what
scared investors about you, you’ll seem more confident, which they like, and
you’ll probably also do a better job of presenting that aspect of your startup.
At the very least, that worry will now be out in the open instead of being a
gotcha left to be discovered by the investors you’re currently talking to, who
will be proud of and thus attached to their discovery. [11]
This strategy will work best with
the best investors, who are both hard to bluff and who already believe most
other investors are conventional-minded drones doomed always to miss the big
outliers. Raising money is not like applying to college, where you can assume
that if you can get into MIT, you can also get into Foobar State. Because the
best investors are much smarter than the rest, and the best startup ideas look
initially like bad ideas, it’s not uncommon for a startup to be rejected by all
the VCs except the best ones. That’s what happened to Dropbox. Y Combinator
started in Boston, and for the first 3 years we ran alternating batches in
Boston and Silicon Valley. Because Boston investors were so few and so timid,
we used to ship Boston batches out for a second Demo Day in Silicon Valley.
Dropbox was part of a Boston batch, which means all those Boston investors got
the first look at Dropbox, and none of them closed the deal. Yet another backup
and syncing thing, they all thought. A couple weeks later, Dropbox raised a
series A round from Sequoia. [12]
Different
Not understanding that investors
view investments as bets combines with the ten page paper mentality to prevent
founders from even considering the possibility of being certain of what they’re
saying. They think they’re trying to convince investors of something very
uncertain—that their startup will be huge—and convincing anyone of something
like that must obviously entail some wild feat of salesmanship. But in fact
when you raise money you’re trying to convince investors of something so much
less speculative—whether the company has all the elements of a good bet—that
you can approach the problem in a qualitatively different way. You can convince
yourself, then convince them.
And when you convince them, use
the same matter-of-fact language you used to convince yourself. You wouldn’t
use vague, grandiose marketing-speak among yourselves. Don’t use it with
investors either. It not only doesn’t work on them, but seems a mark of
incompetence. Just be concise. Many investors explicitly use that as a test,
reasoning (correctly) that if you can’t explain your plans concisely, you don’t
really understand them. But even investors who don’t have a rule about this
will be bored and frustrated by unclear explanations. [13]
So here’s the recipe for
impressing investors when you’re not already good at seeming formidable:
Make something worth investing
in.
Understand why it’s worth
investing in.
Explain that clearly to
investors.
If you’re saying something you
know is true, you’ll seem confident when you’re saying it. Conversely, never
let pitching draw you into bullshitting. As long as you stay on the territory
of truth, you’re strong. Make the truth good, then just tell it. |
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