VC Due Diligence: The Audit of P and S

This is a continuation on my post about David Silver's The VC Due Diligence Process and builds on The 3 Laws of Venture Capital. Both are commentaries of A. David Silver's book Venture Capital: The Complete Guide for Investors. The first of five audits that VC's should do when reviewing investment opportunities is the audit of the problem and solution.

Estimating the Problem Size

The first step in evaluating the problem is to estimate the total size of the problem and then the expected market share once the market has been saturated with competitors. According to Silver, the maximum plausible market share is on the order of 10 - 15%. If the goal is to have $100M+ revenues after 5 to 10 years once the market has developed, the total market size must be at least $1B. There are many methods of estimating market size, so I'll defer on the best method. But an important step in this process is to actually talk to potential customers to gauge whether they perceive the problem the same way and if they would buy a solution to solve the problem. The target here should be to validate the market size and that the market will indeed develop over time.

Characteristics of Attractive Markets

In addition to market size, Silver outlines eight factors that make a market attractive for a VC. He refers to the factors as "Demonstrable Economic Justification". The factors are:

1. Existence of qualified buyers
2. Existence of competent sellers
3. Homogeneity of buyers
4. Large number of buyers
5. Lack of institutional barriers to selling
6. Word-of-mouth is principal form of advertising
7. Optimum price/cost relationship
8. Invisibility of the new company can be maintained

1. Existence of qualified buyers

Potential buyers need to be aware of the problem, interested in it, and have the ability to pay for the solution. If the buyers are not yet aware of the problem (or have a very different perception of it), the entrpreneur will have to spend millions of dollars educating them on it before they sell them the solution. VC's generally don't want to invest in companies that have to create the demand curve from scratch.

2. Existence of competent sellers

Even if there are qualified buyers, the entrepreneur needs a competent and qualified sales and marketing team that connects with the specific buyers in that market. Sales people should be competitive and have operated at a high-level in a competitive environment. Some VC's prefer a three-person start-up team including the "people, pencil, and paper". "People" is the entrepreneur that has the vision for marketing and selling the product. "Pencil" is the manager partner, the person that can make sure things get done right. "Paper" is the finance and administrative perspective, the person that can often be the "nay-sayer".

3. Homogeneity of buyers

Often, entrepreneurs have found a solution that can be applied to numerous problems. The entrepreneur needs to focus on those problems that have a market with the most similar buyers. The market with the most homogenous buyers is the most efficient to address. It is capital intensive to customize your product for multiple markets, problems, and buyer types, which ultimately limits your ability to scale.

4. Large number of buyers

You want your market to have an infinite number of buyers. Or, if there are a small number of buyers, there should either be the opportunity for repetitive sales (e.g. razor-blade model) and/or sales of ancillary products and services (e.g. maintenance contracts, replacement parts, etc.). In terms of how many buyers, again the benchmark is generally a $1B market with no single company attaining more than 10 or 15% market share. The other assumption that Silver asserts is that "anything worth doing will be copied by others who have substantial and excellent management".

Silver also described by niches are not attractive to VC's. To address a niche and launch a product, a VC would likely end up with greater than a 50% equity ownership in a company. There's no equity remaining if the entrepreneur wants to launch a follow-up product. The economics just don't work for VC's.

5. Lack of institutional barriers to selling

Associations in any industry are often setup to (paradoxically) prevent the introduction of solutions to problems that the industry faces. Why would they do so? Because associations are "don't rock the boat" oriented. The current structure of industries often affords its participants high salaries and fat profit margins. New technologies can disrupt value chains and create losers. Entry into markets with institutional barriers is much more expensive.

6. Word-of-mouth is principal form of advertising

In a capital constrained environment, mass advertising really isn't an option. VC's like investments that require minimal amounts of money for advertising. The function of advertising is to create "solution awareness" - not to educate the market on the problem or to create a demand curve. The demand should already be there. VC's want to invest in products and services that 1) have customers that will say it works, and 2) where others will believe those customers and then try the product as a result. A great example that Silver talks about are productivity improving capital for large corporations (e.g. most enterprise software) because sales are heavily reference-based. Books like Crossing the Chasm talk at length about the importance of reference sales, particularly from early adopters.

Two important implications of this are that industries with buyer credibility issues (i.e. where your buyers lack credibility -- e.g. drug abusers) or that require you to attack the consumer mass market are generally avoided by VC's. References and word-of-mouth advertising can't be used when the buyers aren't credible and mass markets require marketing genius, which is extremely rare.

7. Optimum price/cost relationship

The minimum gross profit margin that VC's look for is around 60%. Silver illustrates this with a discussion of the difference between Apple and Osborne Computer Corp. While Apple went with a premium pricing strategy (with 80%+ margins), Osborn went with a low-cost product with much lower margins (~47%) that included expensive hardware components as well as software. Although the company created it own challenges, the company ultimately went bankrupt in part due to sustained losses. Two important lessons for entrepreneurs from this - 1) don't underprice your product and 2) throw in add-ons (don't make everything inclusive).

Another lesson related to finances is to make cash flow projections for multiple scenarios (think Monte Carlo simulation) to ensure you have enough capital.

8. Invisibility of the new company can be maintained

This one is simple - keep a low profile until your product works. There will be many followers and imitators even if you have patent protection. VC's won't invest in entrepreneurs that have advertised before they have an ability to deliver. There's a high likelihood that someone else will beat them to market with a working solution.