There’s little doubt that ambitious start-ups looking for 1st or 2nd round funding face a unique set of challenges not found elsewhere in the business world. They are, after all, what makes building a business so exhilarating and terrifying in equal measure!
As investors and long-time business owners and marketers, we fully appreciate the scale of these challenges and the extent of the threat they pose to a start-up business. Ensuring that the management team both understands these issues and has the plans and resources in place to address them forms a crucial part of our due diligence process.
Our purpose here is to take a critical look at these challenges, how they can be overcome, and how the appropriate resources can be put in place. Hopefully, these musings will be of interest to both the amateur investor community battling to assess the ‘pitch’ and start-up management teams who need to overcome these challenges to succeed.
Achieving stellar growth is the dominant challenge facing all ambitious start-ups. Investors demand it and achieving critical mass quickly is the only way of building long-term sustainability.
However, before we go any further, it’s essential to understand the sort of numbers we are talking about. Forecast annual growth rates over the initial five-year trading period are seldom less than 50%pa but can, in some instances, be well over 1000%! What’s more, much of this growth is ‘front-loaded into the first couple of years of the forecast period.
It’s vitally important to recognise just how big a challenge this is. It would be a very tall order for a large, well-established business with apparently limitless resources. For a small, even if well funded, start-up, the task is enormous, which of course is one of the reasons why so many fail. OK, these businesses are starting from a very low base, so doubling or tripling annual revenues represents a comparatively small amount of money. But, the task is still enormous.
However, the challenge cannot only be framed in terms of growth rates. There are three further factors that start-up management teams need to overcome if they’re to achieve viable scale.
It is reasonable to assume that any business seeking funding will have gone at least some way towards proving the commercial viability of the core product. After all, no serious investor is going to put money into nothing more than a completely untested ‘bright idea!’
In practice, this means that the business will have developed some form of ‘minimum viable product’ that has been tested to a limited degree on ‘the market.’ However, we can also safely assume that this product is not fully proven. Achieving this critical goal is one of the most common reasons for seeking first round funding.
Given that the only viable measure of true commercial viability is how well the product sells within the real market, it follows that product development will continue well into the initial phases of growth. At this stage, the management team cannot know what the fully developed product will look like or how much development time and effort will be involved.
The same problem applies to ‘the market.’ Potential investors will expect the management team to have researched the market, identified potential target segments and to have undertaken testing to gauge attitudes and the likely propensity to buy.
However, because resources are extremely limited prior to first-round funding, experience strongly indicates that initial testing will be undertaken on a tiny subset of the potential market, often selected from within the management team’s existing network.
This preparatory work is very necessary, but, at best, it can only deliver partially validated assumptions. The nature of the actual market and its true characteristics and behaviours are likely to be very different. They can only be learned from experience which, in turn, can only be gained by dealing with the market at scale.
It’s one thing to research a market and gauge reaction. It’s quite another to sell into it at the volumes required to achieve required levels of growth. Even in cases where market testing has involved signing up early customers, it will have been done at very low levels often utilising relationship marketing. The marketing processes required to trade profitably at scale will be very different.
But development and proving of these processes has not even begun yet! Furthermore, they need to take a product to market efficiently and effectively, but the product is not fully developed and the market not fully defined or understood. So process design needs to be iterative and flexible, but it needs to be done fast. The challenge is considerable!
The true extent of the challenge is now clear. The business needs to build the structures required to deliver extremely high rates of growth very quickly. However, the key foundations of any successful business - a competitive product, a well-defined market that needs it and an efficient method of getting the product to market - are not yet in place.
Unless these foundations are appropriately created, there’s a real danger that the business will be built on sand.
As investors and long-time small business owners, we recognise the scale of what’s involved here. We also understand the extent to which management teams are grappling with uncertainty, so we do not expect ready-made answers to all the questions these challenges throw up.
But, what we do need to see is evidence that the team fully appreciates the scale of what’s involved, collectively possesses the skills, experience and breadth of imagination to succeed and is prepared to invest appropriately and at scale.
We certainly cannot claim to have all the answers, but there are several pointers we look for when evaluating any pitch for 1st or 2nd round funding.
Make no mistake, the challenges we have outlined here are all marketing related.
The business needs to generate cash - fast! That can only be achieved through the intelligent application of the marketing discipline.
The business needs to finalise the development of a commercially viable product. In other words, a product that satisfies a market need and that the market is willing to pay for - the application of the marketing discipline again.
The business needs to target its efforts on identified segments where it can win business efficiently and compete effectively - a definition of classical marketing strategy in a nutshell!
The business needs to be able to get its product to market efficiently and reliably - the job of tactical marketing and marketing communications.
The conclusion is clear. Strategic marketing capability is a crucial measure of investment-worthiness for any business pitching for 1st or 2nd round funding. It’s assessed through the profiles of the management team, the business strategy outlined in the pitch and the ability to answer the awkward questions we pose as part of our due diligence process.
The role of marketing is to generate positive cash flow, and it is the only business discipline that does so. (We are treating ‘sales’ as part of the marketing mix here.)
Two critical propositions follow -
So, when we assess the financials in a pitch, we’re looking for projected patterns of marketing investment that look something like this.
Clearly, the level of investment and whether it forms part of 1st or 2nd round funding is down to the requirements of an individual business, but the recognition of the need to invest to drive revenue is essential.
On the other hand, something like this will set many alarm bells ringing very loudly!
A pattern like this implies that the business is intending to invest a more or less constant proportion of revenue, usually derived from an industry average of established competitors. However, the business is not yet established! It has no market position; it has no brand; it’s going to have to invest very heavily to become established.
Consider the following -
Expecting marketing investment like this to deliver the required levels of growth is akin to demanding sports-car-like performance from a car with no fuel. It’s not going to happen!
We need to stress that it’s not merely a question of throwing money at the problem. The focus here is on intelligent investment, which takes us to our third pointer.
We have established that a start-up seeking 1st or 2nd round funding has to achieve stellar growth from a position of considerable uncertainty. We also recognise that a committed, flexible and intelligent application of the marketing discipline is critical to success.
However, it’s important to emphasise the word ‘flexible’ here. At this stage, the marketing strategy is based on little more than a series of assumptions. The process that will be used to deliver the plan has not been built or proven, and the product has not yet been fully developed. Furthermore, the marketing discipline is going through a period of rapid change, so the tools available to the business are evolving quickly and dramatically.
In these circumstances, the development of the marketing infrastructure has to be flexible and iterative. The strategy defines the process, the product and the choice of marketing tools. However, the process generates feedback, which in turn influences strategy.
There’s no room for guesswork or pre-conceived ideas here. Building a business based on fixed ideas on how the product will be sold is exceptionally high-risk, and we’ve seen too many businesses go under this way. Fortunately, help is at hand in the form of the ‘lean and agile’ toolkit - the disciplines that provide a rational approach to building a business in conditions of extreme uncertainty.
If you are not familiar with these techniques, we strongly recommend that you familiarise yourself with them. There is much information out there, but our lean and agile primer might be a sensible starting point.
The key point to note is that the process consists of a constant’ build, measure, learn’ loop to test and refine the product, the strategy and the process. Data is at its core, ensuring that all critical decisions are evidence-based.
In our view, this is the only approach that makes sense, and we would be very unlikely to back a business that didn’t demonstrate a genuine commitment to it. This takes us to our final pointer - the critical issue of resources.
At some point, it’s reasonable to expect any ambitious start-up to recruit its own marketing team. But not now!
The uncertainties are too great, and the need for flexibility and speedy response are too high. In an environment in which the product, the marketing strategy and the marketing process are all in a state of flux, the business cannot possibly know the balance of skills that’ll ultimately be required.
Attempting to build an internal team in these circumstances is both high risk and expensive. It’ll also make it challenging to employ the levels of flexibility required to implement an effective lean and agile approach.
But, access to highly professional marketing skills is a ‘must have.’ Not only does the business have to compete effectively, but it’ll also have to employ continual development of key marketing tools as part of the lean and agile approach.
We’ll take the website as a simple example. It is safe to assume that all start-ups seeking 1st or 2nd round funding will have invested in a functional website. However, it’s equally safe to assume that the site will be under more or less constant development as the business evolves and grows. There’s also a strong possibility that additional sites will be required if more than one market is being targeted, and these developments will need to be fully coordinated with the evolving marketing strategy and broader marketing process.
Who is going to do this development work? It doesn’t make much sense to recruit an internal team since the balance of required skills is not yet known, and the workload is likely to diminish once the business is proven.
Another option would be to use the people who developed the original site. However, in our experience, the majority of such sites are developed on one-off fixed term contracts so, unless the agency is experienced in continual development methodologies, they are unlikely to have the required level of capabilities or experience.
Our view is that flexible resourcing can only be achieved by working in close partnership with a continual development agency with extensive experience of the small business environment. (Full disclosure - We established Priszm for precisely this purpose.)
However, despite our vested interest, the point still stands. Resourcing needs to be flexible and nimble; it needs to be a core part of the strategy and process development cycle; and, within the marketing context, it needs to be data-driven and multi-disciplinary.