The secret to success for startups: invest BEFORE the product is accepted by the market, double the rates AFTER

Original author: Dave McClure
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Dave McClure The

secret of success for startups: invest BEFORE the product is accepted by the market, double the rates AFTER

Sorry ... the article turned out to be long (~ 2500 words). Not for the faint of heart. If you want an abridged version, read the following summary and 3 key statements, then go straight to the conclusions at the end.

Summary: Venture funds are getting smaller (this is good), angel investors' positions are strengthening (also good), but both need to become smarter and more innovative. The cost of launching startups has significantly decreased over the past 5-10 years, and online distribution channels through Search, Social Networks, Mobile Platforms (i.e. Google, Facebook, Apple) have become dominant. At the same time, the number of transactions for the purchase of companies has increased, but their size has decreased, as established companies now buy startups at the earlier stages of their life cycle.

What does all this mean? What prospects and pitfalls does this hold for investors?

Let's start with 2 initial observations of the current market for investors and for startups.

Statement number 1: Most online investors (angels, seed funds, large venture capitalists) have no idea what they are doing. With the exception of a few well-known companies, most large $ 150-250M funds will go bankrupt over the next 3-5 years ... and that's good. However, small investors will have to adapt and somehow stand out from the others in order to make high-quality transactions and survive.

Recently, some very smart guys spoke about the relative [advantages / disadvantages] of [large / small] technology investors, especially about the changes and difficulties that venture capitalists have faced over the past 10 years. Due to the reduction in necessary investments and the average amount of sales, it is now difficult to be a large investment fund (say, more than $ 250M) investing in consumer Internet. And, although I agree that there is a situation in the venture capital business, the book described how to get out of the crisis of one baseball team, such a conclusion would be too superficial ... and it misses more reliable things: the tendency towards investor specialization (or lack thereof) and importance phased investment depending on the maturity of the product / market (I will talk more about this later).

In my opinion, when investing in online startups, the size of the fund is not of paramount importance. I am deeply convinced that the $ 10M-100M seed funds are more manageable and better aligned with the interests of entrepreneurs than the "traditional" $ 250-500M + funds, but in the end there will be only a few winners and a lot of losers at both ends of the spectrum. There are likely to be more losers among large funds than among small ones, but there are still many factors that can affect success or failure.

No, the main problem is that investors have become incredibly lazy and smug over the past two decades when you look at their activity and IRR. Recently, the consumer Internet has brought with it a flurry of technological and behavioral changes that have led to a staggering reduction in the time and money requirements for the distribution of goods and services among 2-3 billion Web users.

Let's look at all this in more detail:

INTERNET has changed the lives of BILLIONS of people on the planet is VERY IMPORTANT - at the same time, most investors and lawyers conclude transactions by fax and regular mail.

To hell. This. Noise.

Most investors working with consumer Internet do not even know what they are doing. They are unsuccessfully chasing after the IRR, but most of them should stop and not disgrace ... RIGHT NOW. Their principles of investing are doubtful, knowledge of the subject area is limited or completely absent, and their desire and ability to create innovations is minimal. They just cut coupons.

Well, ATTENTION, OLD TRADERS - you, Gentlemen Venture Capitalists 1.0, are on the verge of EXHAUST ... and you are waiting for the Schumpeterian share that you have long deserved.

So it is: most investors are Dinosaurs, and the World Wide Web is an Asteroid that fell on the planet, which entailed a huge explosion 15 years ago. It will take another 5 years for the clouds of ash, the nuclear winter of Browsers, Search Engines, Social Networks and Mobile Devices to kill tyrannosaurs, but this is already inevitable. The lucky ones begin to dominate and by 2015 there will be many more investors, such as Jeff Claviere, First Round Capital, Y-Combinator, TechStars, Betaworks, Founder Collective than all Sand Hill VC there (funny, it turns out that all the innovators are outside the Valley, is not it?).

Now let's look at the changes that have taken place and how you can adapt to them and become a Modest Investor 2.0:

Statement # 2: There is a great opportunity to create profitable Internet startups for $ 1-5M that a) would become commercially viable, b) would predictably attract customers through online channels (search, social networks, mobile platforms), and c) they could would be sold for $ 25- $ 250M.

Historically, Venture Capital is associated with large, risky, capital-intensive investments in order to achieve two main, often expensive, goals:
Create a Product.
Attract Customers.
Now, in the past, PRODUCT means creating a lot of expensive things (a lot of hardware, disks, workstations, box software, chips, network equipment, browsers, search engines, social networks, etc.) involving a large number of people for many years. I mean 50-100 + people who create nonsense that does not make a profit for a long time. There is a lot of trouble and expense before you get the first customer.

And to make matters worse, many startups who have received venture capital investments target CUSTOMERS among large technology corporations or government agencies with long sales cycles that require expensive, direct, dedicated sales managers ... which also takes a lot of time and money. Our massive sales and marketing campaigns are conducted using expensive print, radio and TV media. Sales cycle - annual, requiring constant actions to achieve quarterly or annual goals by generating revenue from licensing, support, upgrades.

Finally, many of these companies were created to enter the stock exchange after many years of work and several rounds of investment, after which the share of the entrepreneur in the business remained negligible (often a few percent), and the expected amounts of sales transactions were huge, hundreds of millions, if not billions dollars.

Going back to 2010, let's take a look at these basics through the prism of Internet startups:
PRODUCT now basically means a website or service that runs on cheap / free open source software, hosted in the cloud or on cheap servers, developed in a few months (or ON THE WEEKEND!) by a small group of 1-5 developers who are constantly testing and improving it in real time with working users
Market / Marketing now often means using a variety of online distribution channels through paid / organic search (SEM / SEO) on Google, viral / social ads on new media and social networks like Facebook, Twitter and YouTube, as well as the fast-growing market for Apple mobile platforms iPhone and Google Android. With the exception of search, most of these channels did not exist 5 years ago, while at the same time, their audience reaches 100M-500M + users with inexpensive and measurable marketing campaigns that allow even a small team to reach billions of people.
INCOME can now be obtained easily through a variety of online payment systems, transaction systems, virtual goods, subscriptions, contact generation, CPM / CPC / CPA advertising. Many people now buy goods online, and many companies are bought only for the sake of the user base, despite the profitability. In other words, guys are starting to get paid! Cash! It's good!
To summarize: the PRODUCT development cycle is shorter, the necessary materials and resources are cheap or free, the development teams are smaller, and new services and their combinations are created on top of the existing ones, which are already incredibly useful in the cloud due to their functions, data, network effects, and software interfaces. MARKETING costs are now less thanks to a variety of widely available, low-cost online distribution channels that can be used more transparently and predictably than ever. High-speed channels at home allow you to use video and other rich content for everyone who has a cable or satellite TV in the house. INCOME can be obtained simply and reliably, through direct business models and online payment systems that are becoming mainstream around the world ... such as

Finally, when more and more technology and Internet companies become profitable, they, in turn, turn into potential buyers for startups with innovative technologies, necessary products and services. Using their larger client bases to boost sales, they can buy smaller companies looking for a cheaper way to reach new customers. However, as more and more such companies grow and compete for the right to be bought, more and more startups are bought earlier and for less money than if they had grown to the size required for an IPO. As non-technology companies seek to buy innovation and experience in online services, there is a growing trend towards a large number of increasingly smaller business sales.

Okay, this is all a fortune-telling on the coffee grounds, but let's look at the basics and the best approaches to investing in consumer Internet startups.

Statement 3: The process of investing in startups can be divided into 3 specific phases with clear objectives and results:
PRODUCT = finding a client’s problem and solving it (minimally viable), usability / usability
MARKET = market size estimation, campaign testing, cost of attracting a client and conversion
INCOME = increase in revenue and / or market share, optimization for profit.
In many respects, this applies to the application of Customer Development (Steve Blank) and The Lean Startup (Eric Ries) techniques for investing, in particular, how to research, improve and determine product acceptance by the market (Sean Ellis, Marc Andreesen), in other words “CLUTCH”, to and after investing.

This, in fact, is the basis of my investment principles: Invest before the product is accepted by the market, measure / test whether the team is able to achieve it, if so, then take advantage of your opportunity to proportionally invest the project in the next stage AFTER the product is successfully marketed. This is akin to playing blackjack: you make low bets at the beginning of the game, and towards the middle of the deck, when you see that you have good cards in your hands, you begin to increase bets.

Let's face it - most venture investors are sheep. They like to play dishonestly. We want to be sure that there are already customers, revenues, and also an exclusive thing called CLUTCH. Unfortunately, it is obvious that if you already have clients, income and CLUTFUL, then there will be many investors in the trough, the struggle for the right to invest will be fierce, and the price will be high.

So how do you invest small amounts and then know when to continue and invest more?

It’s not so difficult, I’m serious.

INVEST EARLY and SMALL AMOUNTS in people you think are smart, who have created promising products. Find out if they know how to improve, get feedback to improve the product or its promotion. Find out how you can measure the conversion for their business and the value of one customer. Then, IF you see that the metrics are improving, and the value of the customer base / business is growing ... then INCREASE RATES.

However, this happens in 3 specific steps:
PRODUCT: Find a [reasonably large] consumer segment with a significant problem / acute need for something and develop a functional solution for them (Minimum Viable Product - MVP). I call this stage ACTIVATION. You should also make sure that using your product is exciting enough to do it again (HOLD).
MARKET: Try scalable distribution channels that will allow you to attract a large number of customers for money that is less than what you earn (ideally, <20-50% of annual income so that some reserve remains). You can also go back to point # 1 to review a few things, or check out completely different marketing campaigns and scaling concepts. If you're lucky, you can find a way to get users to talk about you, spreading the word wider and wider.
INCOME: let's hope your MVP is already significant enough that people will be willing to pay more for it than nothing. Regardless, the goal is to test and optimize product / marketing combinations to generate positive cash flow when scaling at short intervals (or long if you have a source of funding). I prefer simple business models, for example, transactional models and e-commerce, subscription, affiliate models.
Ideally, if you have the opportunity to invest in a finished product AFTER the entrepreneur forced him to work, but sometimes they have not had time to do it, and often they still have to turn around to find an interesting segment that allows them to scale and make a profit. Anyway, I believe that entrepreneurs who understand their customers are able to create a minimum viable product in 3-6 months and <$ 100K. Sometimes it takes more time and money, but basically it is. If it seems to you that entrepreneurs are coping, increase rates.

Next, you need to be able to improve user experience and retention, make them love your product even more. If you can do it well, your customers will replace your marketing department ... with a low price. Even if you fail to achieve wide publicity, you will still lower the cost of attracting customers through a social multiplier. Regardless of this, you need to find a SOME scalable distribution channel, which later could bring a positive cash flow. Let's hope that it will cost no more than $ 1-2M and require less than 6-12 months. But all these expenses should be directed to MARKETING channels and hypothesis testing, and not to improve the product ... you can adjust to find new ways to use it, but NOT TO add new features. Actually, you must want to remove them (read, KILL THE FUNCTION). If you have scalable distribution, even without self-sufficiency, increase your bids.

Finally, if you already have a finished product (I hope a GREAT product with good activation / retention / recommendation indicators) and you have ideas about scalable distribution channels that will lead to non-zero revenue events (or intermediate events, such as long-term use, effective for partners behavior, advertising CPM / CPC / CPA), then you should be set to make a profit in the foreseeable period of time, which you can finance. This period can be very expensive for many businesses, but I prefer to think that $ 1-5M and 1-2 years will be enough for my startups. Again, if everything goes to the point that you can do it, raise your bets.

To summarize, you need to think about the following steps to reduce risks and create company value:
Product: $ 0-100K, 3-6 months to develop a minimum viable product, at least for multiple customers. Achieve a slight fit to the market.
Market: $ 100K- $ 2M, 6-12 months to test marketing and distribution channels, understanding the scalability and cost of attracting customers, conversion to some events with non-zero revenue. Achieve a significant fit to the market.
Income: $ 1-5M, 6-24 months to optimize the compliance of the product with the needs of the market to achieve positive cash flow.
I will have to edit this text a bit, as I wrote it in a hurry to return to other projects as soon as possible, but I think that I expressed most of what I wanted to say at this point.

I would be grateful for feedback and comments on everything that seems nonsense, can be corrected or simplified.

Translated for blog by
Konstantin Medvedenko

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