Uncovering the Best Predictor for Startup Success
Uncovering the Best Predictor for Startup Success
An investor's perspective on market context and opportunity
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In every early-stage VC marketing spiel you'll notice that they always talk about backing people with a big vision.
Not product, not market and not investment terms.
And to some extent that’s true.
People are crucial for enduring success in a startup. The founding team must be strong and they must be able to hire strong employees.
However, there’s an even stronger force that plays a larger role in the success of a startup than you may think.
The only investing framework you need
When a great team meets a lousy market, market wins
When a lousy team meets a great market, market wins.
When a great team meets a great market, something special happens.
Andy Rachleff, Founder of Benchmark Capital
As VCs we see a lot of 2x2 matrices, this is by far my favourite.
It's a pretty easy framework to follow, identify good markets and then identify the best founders in those markets and give them money. As Don Valentine puts it "I like opportunities that are addressing markets so big that even the management team can’t get in its way.”
In early-stage venture, it's easy to focus on what the MVP looks like, how much they're raising, and how many pilot customers they may or may not have. In the long run, it's hard to know whether any of that actually matters. However, the two things that do matter are the Market and the Founding team.
As I covered in my last article, the market that a startup is operating in, matters because it dictates basically everything about the business. It dictates what your product is, what your GTM strategy should be, the ability to access and entice talent and the overall potential for the business.
The founding team obviously matters as they are the ones who need to be best placed to access the opportunities that their chosen market provides them. If they don't have the skillset or the potential to develop a skillset that will allow them to access these opportunities then they end up as mediocre founders.
Determining Founder-Market fit is by far the most impactful thing you could do as a VC when making a decision. They are synergistic to the extent that a stellar team probably won't choose a mediocre market to build in. If you find that to be the case, then maybe the market isn't actually mediocre, or the team isn't so stellar.
What makes a stellar market?
Analysing a market is such a pie-in-the-sky exercise.
There's a lot of work that can be done to unpack a market using both a top-down or bottom-up approach, and you can build intricate models that will give you a (spurious) view of what the market size is.
Rather than focusing on a given number, I like to use a framework called the 3 C's.
Competition
Competition is an interesting factor to think about in the context of an investment decision. First and foremost, I hate competitive markets. Peter Thiel puts it best when he says "Competition is for losers".
However, in the world of startups, typically there is an incumbent being disrupted by multiple different startups each trying to own a piece of the pie and it can be unclear why a certain startup might win. You'll find startups with $100s of millions of dollars raised or those backed by first-tier global VCs which can cause worry for investors looking to back a startup's small pre-seed/seed round.
Understanding competition is an exercise in sifting between signal and noise. Brand name VCs and large fundraises are noise. They make a startup appear successful and famous, but realistically, you don't know what the state of business is like unless you have an inside view of the company. So, when thinking about competition, I usually follow this process:
Sign up for competitor products, go through onboarding flows and understand the nuances of particular features. Bonus points if you interact with customer success or account executives.
You can learn a lot about a startup's priorities and internal culture by acting as a potential customer and keeping an eye open for peculiarities.
Once you've understood the different nuances of the product, reverse engineer their journey to how they got there. Digest different podcasts, articles and other media that the founders might've done in the past to understand their vision, but also where they were at different points in the journey. If you can find release notes for the product, that'll tell you how quickly they can ship the product and their overall output as a team.
Request the founder to provide a competitor analysis. This will reveal their understanding of the competition and their perspective on why specific features have been developed and their usefulness. You'll also get an insight into the founder's mind around how they think about their competitors. E.g., if they are dismissive of competition, then maybe they are too arrogant etc. Additionally, the competitor analysis can help demonstrate where the founder's product is placed in the context of its competition.
Once you've done this work, you should be able to glean the following:
An insight into a founder's mind around how they react to competitive pressure and their level of paranoia and optimism.
An understanding of the different cultures within competitive startups and their ability to ship product quickly and take advantage of market tailwinds.
Personally, I believe the founders you back need to have a certain level of optimism to actually be effective at their roles as a founder, but also be clear-headed and paranoid about competition encroaching on their territory.
In that same vein, looking at competitor products and the speed of iteration can give you a nuanced view of how fast the market is really growing and whether it is ripe for disruption.
Customers
By looking at a startup's target customer base, we can know two things:
A rough estimate of the potential Total Addressable Market
The speed at which the market could potentially grow.
The basic TAM calculation is effectively Price (P) x Number of Customers (C). This can give you a directionally correct figure but is open to misinterpretation and overzealous filtering by VCs. If the number doesn't seem large enough to be 'Venture Scale' then VCs will pass on the opportunity quickly. If it's too big, then it seems unrealistic. Without context, this number doesn't mean anything.
Determining the number of customers in your target market is hard and largely dependent on your Ideal Customer Profile (ICP), and business model. If your ICP is a large enterprise, with an engineering team of 1,000 + people, then the number of customers in your target area would be minimal. And if your business model is volumetric rather than a monthly subscription per user, then that changes the equation slightly.
It's hard to provide a prescriptive way of thinking about the number of potential buyers in a certain market, so I'd urge you to try and think with first principles, especially if the startup in question is trying to create a market from scratch with a view that the buyer pool will dramatically increase over time (e.g., Canva)
Moving over to P, the price of the product is what the startup charges their customers. However, at the earliest stages, it's hard to know what the right price actually is, as well as the upper and lower bounds. More importantly, it's unclear whether the price of the product will increase or decrease with extra features or more competition.
It's possible to segment the market heavily and incorporate multi-tiered pricing assumptions, but that's too much guesswork. Instead, you can base your initial price estimate on current comparables in the market with a 20% discount, or run a quick and dirty pricing process focusing on whether the product is focused on increasing revenues or decreasing costs. If the former, then price the product at a reasonable percentage of the forecasted revenue increase. For the latter, price the product at a reasonable percentage of the forecasted cost savings.
To pick the percentage, choose somewhere between 5-20% as a rough guide. The price of your product depends on your Ideal Customer Profile and their size. If you're targeting enterprises, assume 20%, or for consumers, assume 5%.
Again, this is a hugely generalised approach towards getting to a justifiable TAM figure. The goal of the TAM figure is to be directionally right, and not precise.
What's more important is how fast the market grows and the upper limit for growth. A lot of people miss the fact that markets can grow in size with the introduction of new startup entrants. However, this growth is largely dictated by sales cycles and the speed at which value is created for the customer.
Sales cycles for consumer products can be short and the speed at which value accrues can also be quite short. As a result, consumer products generally grow the fastest compared to SaaS products (as a side note they can also die the quickest.) On the other hand, sales cycles for enterprise customers are long and then the speed of value accrual is also longer after factoring in onboarding and upskilling time across the enterprise. As a result, the growth rate might be slower for businesses targeting this segment. This can significantly impact the future successes of the company with a direct impact on revenue but also flow-on impacts through product iteration cycles and hiring.
As an investor, your job is to parse the tradeoffs between the current TAM, target customer base and how that funnels into the growth rate of a market. Different investors will have different preferences for what they like to see for these factors.
Cycle
Finally the market cycle. Less granular than the previous two C's, the market cycle encompasses both macro and micro headwinds and tailwinds as well as the state of capital markets for a particular industry.
We've largely covered much of the work you need to do to assess micro tailwinds and headwinds in the previous 2 C's, but it's worth zooming out and looking at the full picture. On the macro level, you need to think quite broadly about how the world works, and what the incentives are for the market to grow. That sounds wishy-washy, but a practical example would be video conferencing software. Prior to COVID, adoption was slow for this software, but through COVID and the larger macro shift to remote work, companies such as Zoom really took off and probably went beyond many of their investors' expectations.
However, over the last couple of years, they've struggled due to more competition and a slight pullback in the shift towards a fully remote world. These are all macro tailwinds and headwinds. Understanding where we are both on an industry level and also broadly in the context of the world is important to fully understand and recognise the potential of a business. Looking at edge cases and understanding the potential existential impacts is especially pertinent in today's world with capital uncertainty in funding markets and the impending threat of AI in rendering some products obsolete.
Whilst this might not fully guide your investment thesis, its important to have a clear-eyed approach towards understanding how a business might fail with different macro shifts.
Tying it all together
So far we've largely talked about market context and opportunity and how you assess that. The subheading for the previous section was "What makes a stellar market?" but what constitutes 'stellar' is subjective. Some investors might be willing to take a bet on markets that are not fully evolved yet, and others will only invest in well-established markets. What I have given you are the general tools to be able to perform analysis with data to distinguish that for yourself.
When thinking about founder capability, again, it is a subjective decision. Different people will be drawn to different personalities. But what should remain consistent across all founders is their ability to cut through the noise and be clear in their reasoning and thinking about why they are building in a certain market. Realistically, they should be able to give you answers to most if not all the questions that I've asked you to think about when evaluating a market. They should've already done the hard work in deciding whether a market is stellar well before you meet them. Stellar teams choose stellar markets to build in.
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Abhi