Editor’s note: Investor and entrepreneur David Gardner is the founder of Cofounders Capital in Cary and is a regular contributor to WRAL TechWire.
CARY – Early stage investing is said to be the riskiest investing one can do. Many angel groups and early stage ventures funds report that over half of their pre-revenue investment companies fail. That is why most investors prefer to have revenue and data to analyze before making a bet. They want to see models and forecast based on proven assumptions that have been historically validated.
It is true that investments are highly de-risked once a company has been operating for a while with growing revenue but having these cards turned over prior to placing your bet comes at a very high price. Your investment dollars at this stage typically only have one tenth of the buying power they would have wielded when these companies were still pre-revenue.
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Wouldn’t it be great if you could have the data of a later stage company but the valuation of a pre-revenue startup?
There is a way to get a lot of that valuable data you need before a company has revenue or even a product but it requires some work.
I encourage most of our entrepreneurs with an idea to avoid writing software or building a product of any kind right out of the gate. Most of the time, all you need is a good sales deck laying out what your product will do and how it will create value for customers.
Next, you need to roll up your sleeves and start presenting to perspective customers. We profile the decision makers/buyers for our theoretical product and reach out to them. We tell them that we are innovating in their space and would love to hear their feedback on what we are building.
Most busy executives don’t like sales calls but they are curious about innovations and new technologies in their industry. They are also usually flattered that we value and want their advice.
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Once you’ve had enough of these discussions, you start to get a good feel for how important your offering (if it really existed) would be considered. You will start to measure if your offering is a must-have or just a nice-to-have. You will gain a ton of insights into what else your product could do, substitute solutions and pricing constraints you may face. This is an iterative process as you integrate your learnings, modify the sales deck and line up more meetings.
Often you will discover that there is not a market for your solution, it’s not a very big problem or the market is not addressable enough or willing to pay enough for your solution to cover your cost-of-sales. Sometimes, however, everything just falls into place and potential customers show real enthusiasms for your imagined solution to a timely problem they are facing. They even agree to be beta customers once the product is built and volunteer their continued support.
I often say that we will invest in a pre-revenue startup but rarely one where we don’t already know who the initial customers are going to be. This is the part I call “legal insider trading.” If you know about big pending deals that have not been announced in a public company and invest, that’s a crime but doing so in private startups is not only legal it’s encouraged. My point is that it is possible to get pre-revenue startup valuations while assuming only slightly more risk than investing in a company that already has some revenue and customers. You just have to be willing to do the work to gather the data points.
There is one other huge benefit to using this investment model. While going through this process you really get to know your entrepreneurs. Any investor worth his or her salt will tell you that the management team is by far the biggest factor in deciding to invest. A bad idea with great entrepreneurs will always make you more money than the other way around. Watch your entrepreneurs carefully during this process. Are they coachable? Are they flexible, willing to modify their approach and pitch as new data points are gathered? Give them homework and see if they get it done. Do they have the passion and level of activity a startup requires? Are they pushing you for next steps? These are all very good signs.
There is still plenty that can go wrong in any early stage company. Even with this process you can lose money but if you have lined up solid industry beta customers and you have vetted your management team through the process then you have significantly reduced your risk. Make the investment and lock in your pre-revenue valuation.
