Welcome
Hey there Early Stagers…
This week I had many conversations with early stage founders which gave me a fresh perspective on a few topics we are going to dive into in this week’s edition.
These are 2 very critical mistakes that founders do that are costing them a lot of money.
So take a zip of that coffee and let’s dive in…
Yours truly,
Avinoam
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A Race With NO Winners
On my website I have a Product Market Fit readiness quiz (you can take it here). One of the common mistakes I see when asking founders about their business model is that it is very similar to the competition.
The two most common answers are “I do something similar to the competition but I am cheaper”, or “We have the same features as the competition but we structure them a little differently compared to the competition”.
Both answers are not good because they mean you do not have a strong differentiation. To understand why this is bad, we need to talk about how people make decisions.
How People Make Decisions
Imagine needing to buy a car. How would you choose? A car is something very personal, and different people have different references.
If you’re a car guy, you probably know exactly what you want. But this is because you spent hours researching which car is better. You compared horse power, engine size, fuel consumption, tire size, gear manufacturer, turbo or atmospheric and so on.
You know your shit so every little detail matters. You know that when you meet your friends (which are also car guys) they are going to grill you on every little detail and you need to be able to justify your decision…
But what if cars weren’t your thing, and all you needed is to get from point A to point B comfortably. In this case you’d probably look at the price and maybe some amenities (A/C, radio etc.). If you don’t know your shit, they simply don’t matter…
This brings us to the topic of decision making. Different people use different criteria to make decisions. The criteria are defined by your level of knowledge about the subject and your personal situation (finances, preferences etc.).
This is how everyone makes decisions. It’s how every person thinks and operates, and you are no different. We all want to make the best decision. But what do you do if you need to make a decision in an area you know nothing about? You go to your default criterion.
Price…
Market Efficiency
When a market matures and gets crowded, competitors are becoming more and more similar. Everybody has the same features, the same quality and are working in a similar business model. This eliminates all the different decision criteria and leave only one, the price.
The lack of differentiation competitors to push prices down. This starts a race to the bottom which kills all the small players and runs profitability to the ground. It’s a race where everybody lose.
Even the customers lose because the price cuts force manufacturers to reduce quality to be able to compete.
This is called market efficiency. The market stabilize around a price that will allow manufacturers to produce but with only minimal profits.
This might be a great market to disrupt, but not for a startup that’s trying to do more of the same (which begs the question, is that really a startup?)
Winning the Race
In a race with no winners, the only way to win is to not participate. This is true for every young startup who wants to enter (and win) the commodity race to the bottom. Doing more of the same and hoping to come up on top is simply not going to work.
The only way to win is to identify something that will set you apart from everyone. To create a completely different category that you can dominate. If you find yourself doing things like your competitors, it’s time to stop and go back to the drawing board.
When back at the drawing board, it’s time to ask yourself what unique solution can you bring to the table. What specific insight you have that nobody else noticed. Who in the market is not getting their problems solved, and why.
When you’ll have answers to these questions you’ll know you’re on the right track. Then, and only then, you’ll find a good enough reason to exist. You’ll see that going this route will be very different than everything you’ve seen so far.
And that’s how you win the race…
Why startups Can’t afford the Race
Startups are growth oriented entities. The fuel that keeps the engine running is venture capital which demand fast growth, and growth is expensive. This means that startups must operate with high profit margins in order to fuel that growth.
Otherwise they will have to raise additional funds from more investors, but this is not sustainable. As a founder, you will lose too much equity and the grind will not seem so valuable any more…
This is why startups can’t play the commodity game. They must find a way to disrupt an industry or a big enough competitive advantage to enable those high profit margins which are required to fuel that fast growth.
This means that every startup must have a good enough reason to exist. It must have a unique approach to the problem it solves otherwise it can’t avoid that race to the bottom.
So, I urge you to ask yourself, why does my startup exist? What is my competitive advantage? Can I charge these high profit margins?
If the answer is no, you need to stop what you are doing and go find the answers that will change that no to a yes…
SAFEs Stats You Should Know
Fundraising is one of those things every early stage startup has to do. But when negotiating with investors, founders are usually the underdogs due to lack of experience and knowledge about the process. Not to mention the superior sophistication, viability and business acumen an investor have over most founders.
This is why one of the focus points of this newsletter is to enrich your knowledge and understanding of this process.
A SAFE (Simple Agreement for Future Equity) maybe the most common vehicles for early stage fundraising. It’s standardized and balanced which save a lot of legal fees for the startup and give them only 2 -3 parameters to negotiate which streamline the process and help in any future due diligence.
Here are a few statistics to keep in mind about SAFEs from Carta.com:
- 80% of SAFEs were post-money, which is the YC default. Pre-money SAFEs, which are more favorable to the founder, made up 20% or so.
- SAFEs made up over 90% of fundraising in SaaS, Fintech, Gaming, and Edtech.
- The only three industries where Convertible Notes still took in at least 30% of all funding were Medical Devices, Pharma/Biotech, and Energy. Hardware saw about 25% CN funding.
Red Flag Terms for Seed Stage Startups
Last week at Carta’s Innovator’s summit there was a term sheet teardown panel which highlighted a few important terms that if found on your term sheet should indicate a big red flags.
These terms, if found in your term sheet would turn future investors away and will hurt your future fundraising efforts.
These red flags are:
- Non-standard liquidation preferences. The panel gave the example of a 3x liquidation preference (in a liquidation event that investor demands to get 3x his investment) if a company sells for less than $100M and of bridge rounds with greater than 1x, plus participating (When investors get their liquidation preferences plus percentages of what’s left for the common stock).
- Side letters with every angel investor, giving every investors unique terms. The panel noted that some lead Series A investors require all side letters be terminated when the SAFEs convert to streamline the company’s admin going forward.
- Questionable board composition/non-aligned control. Board composition should make sense for an early stage.
- Super pro-rata rights. This is where an investor has the right to purchase more than its pro-rata percentage in future rounds, which can limit future fundraising options.
- Too much dilution (this one is obvious). If the founders have given up too much before the first priced round. The rule of thumb here is founders keep >60% ownership prior to Series A.
- Pay to play. This is where if an investor does not invest its pro-rata amount, it loses rights. Investors hate this unless they are the one demanding it.
Most investors find any deviations from the standard SAFE a problem as it require lengthier due diligence and higher legal fees.
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Your #1 Priority in Any New Startup
This week I started (again) interviewing early stage founders to try and better understand their struggles. I do this every so often because it keeps me in touch with my audience and remind me why I am doing what I’m doing and show me where should I put my focus.
From those conversation there is a reoccurring theme that keeps repeating. A founder has a product, but he is struggling with the GTM strategy.
To me, this is a solution in search of a problem. Because if you don’t know who your market is, or you don’t know how to approach it, it means you’ve developed a product without really talking to your market.
Look, I get it. It’s super exciting to think of something and run off to build it. I almost did the same mistake myself. It’s in our nature. We get excited about something and we want to do it.
But startups are all about risk mitigation….
An environment of uncertainty
Startups are risky, we all know that. But what does this “risk” mean. If you break it down to plain english, risk is the possibility of things to not work which in a business environment are all the things you don’t know.
Now, because startups usually try to make something new and innovative, many things are unknown, therefore many things can not work, therefore the high risk…
There are 3 approaches to mitigating uncertainty:
- You research and try to find evidence (A.K.A. someone else’s experience) that what we’re doing works.
- We try it out yourself and test.
- You hedge against the risk. You can build a plan B (and C and D…) or you can insure against it so if something does go wrong you’ll get compensated.
In the startups world we can sort of do all of them…
We can do market research to see if what we’re doing have already been done. Which begs the question of why should we even do it as a startup. But at least it stops us from wasting time and money.
We can use other people money (i.e. investors etc.) to fund our startup. This way if we don’t succeed, at least we’re not losing as much.
And lastly, we simply try to validate and eliminate the risks with small measured experiments that push us closer to our end product/goal (did someone say Lean Startup…)
But how do you know what to test for?
It’s all about prioritization
Once we understand that we are going to operate in an environment of uncertainty, all we need to do is map out all the things we don’t know. You can call it your assumptions vs. facts list.
Once you have that list, you can start thinking of which ones are most critical (show stoppers) and which ones are easiest (fastest, cheapest) to test. If you find this difficult, don’t worry, CB Insights did some of the work for you.
If you look at CB Insights report back from 2021 about why startups fail, you’ll see that no market need is the #2 reason with 35% of startups quoting it as their reason for failing (I actually think that if you objectively look at the reasons they laid out, you can add a few more reasons to the no market need bucket).
I hope that from this, we can all agree, that validating the market need is your #1 priority. This goes even above technical feasibility. It means that the first thing you must do is to validate a market need.
But how do you do that?
How to validate market need
a few years back my wife started talking to me about one of her clients. She was a dog trainer and this client owned a dogs pool. Not a spa (which would make sense), a pool. I kind of laughed at the idea and thought this was probably a struggling business.
But then I went to see the place…
It was a large building with 3 inner pools and one big playground. It was packed with dogs. When I started talking to the owner I found that this was an experienced entrepreneur with a large exit under his belt.
I was dead wrong, and I learned two lessons that day:
- Never judge a business idea based on your perspective.
- Always test the water first…
In my conversation with the owner I asked him how he thought about the idea. He told me about how their dog loves the beach but at winter it’s hard to go. So the idea of the pool for him made a lot of sense.
But he was no fool, he knew that him needing it was not enough. So he opened a Facebook page for a dog pool and started inviting people to register. Only when he had 2500 interested customers did he take the plunge and started working on building the place.
He verified the demand prior to investing by pre-selling the product. And you can do the same…
The best way to verify a market need is to simply sell it before you build it. This is true for every business idea you can think of. If you can’t sell it, why even bother building it.
You can build a landing page and run traffic to it.
You can cold call potential customers and make them an offer
You can run local ads in the newspaper
It doesn’t matter. The idea is to get people to want to buy (the closest you get them to an actual purchase, the better) before investing time and energy in building anything.
I hope this lesson saves you a lot of time and efforts.