This is the fifth in the series of articles on a little drama that I have been calling “An Entrepreneurial Space.” If you haven’t read the previous chapters, you might want to look them up prior to reading this one, as they provide some valuable context.
So far in the series we have introduced the main players that appear in the life of an entrepreneurial space company: “The Founder” — who is trying to convert their “Big Idea” into a viable business, “The Investor” — who generally provides the early funding for that process, and “The Customer,” who is ultimately the object of the whole exercise.
In this article, I want to pick up where we left off last time by talking a bit more about customers. Specifically, to talk about another word that is often used as a synonym for customers. I speak of “The Market.” The term “The Market” is often used as if it is also a person in our drama.
And that misunderstanding can be the source of some significant unhappiness for Founders and for Investors – and maybe even for customers. So, it’s worth talking about in a bit more detail. First, it’s worth talking a bit about how the discussion of “The Market” comes about – and why it dominates discussions among many Founders and their Investors. Usually, I think, the discussion arises because of, again, questions about growth. Specifically, how to achieve growth and how much is required. To understand why this is such a pervasive question I want to introduce something I call “The 50x VC Equation.”
This concept was revealed to me during a conversation with a founder. In this case I was one of a group of outside advisors meeting with the founder. One of the other advisors worked for a venture firm and had pretty deep experience in funding companies. When asked by the founder about how a VC firm would view the company’s growth potential, that advisor basically put it in the following context.
Let’s say a venture fund invests $2 million in a new firm. The fund and founder agree to a valuation of $10 million for the company, meaning that investors have bought a 20% stake. At some later date those investors would like to be able to sell their 20% stake for $20 million – thus having achieved their “10x” increase.
Now, a typical way of setting the value of a company — once it is operating — is to use its annual revenue as a baseline value. There are other ways, but this is typical and so it is a good rough estimate. Therefore, in order to achieve the goal of the venture firm, this company would need to have a “top line” of $100 million at some point within the next 5–7 years.
$100 Million…in 5 years…in order to justify an investment of $2 million today.
Let that sink in.
In other words, if, as a founder, you approach a venture fund for an investment, they will expect that you will be able to predict a revenue stream that is 50 times the size of the investment you are looking for in a very finite amount of time.
That is what I call the “50x VC Equation.”
Now, this does not mean that every company that secures investment grows at this rate. It does not mean that companies that grow at less than this rate are not successful, even in the eyes of their venture-based investors. But it does mean that any founder that wants to raise money in the venture market is going to have to be able to demonstrate that such growth is possible. This is because every venture fund that the founder approaches will use some form of this “50x VC equation” as part of the early vetting of the companies they talk to. And venture firms talk to A LOT of companies. So, such funds need some kind of filter to decide which ones to select for more detailed discussions. The plain fact of the matter is that companies that can demonstrate the right solution to The 50x VC Equation are more likely to make it past that filter. Companies that don’t, won’t make it to the next stage.
So, early on, smart founders learn – and are taught – that they need to have a credible story about how their company could grow at the rate that will generate the volume of sales they need to get the right answer to the 50x VC Equation.
Founders learn, and are taught, to do this by referring to “The Market.” This market is a way of collecting all their potential customers into a single number. This number, often referred to as the company’s “Total Addressable Market”, or TAM (to give it its fully jargonized label) is a construct that allows the company and potential investors to judge the growth potential of the company and its idea. In effect, it is a way of saying how much business the company could eventually have, based on the problem it is solving and the expected needs of its prospective customers. This market number effectively sets the upper limit for the company’s growth.
Clearly then a smart founder who understands the 50x VC Equation will have satisfied themselves that there is TAM that is at least as large as the 50x sales target they must justify. In truth, the market should be several times as large as that revenue target in order for their claim to be credible. Armed with this certainty, the founder will set off to find Investors who can be convinced that this is the case.
And so, when Founders and Investors discuss business plans and strategies, the discussion will naturally centre around The Market and how to address it. If the Founder and the potential Investors find common ground, a transaction may be completed, and The Founder will be sent forth with the investor’s’ cash in hand to execute the business plan and sell their product or service to the Market.
At which point the Founder will discover that Markets don’t buy things. Customers do.
Now, I guess I need to qualify that sweeping statement just a little. In the case where sales volumes are high and transaction values are low it is possible for “The Customer” to effectively become a statistical quantity. In such a business, it is perfectly normal to abstract the mass of customers into an “average customer” that represents The Market and to design products and strategies to appeal to this market. But most space companies are not in that kind of business. Certainly, most space start-up companies are not. There are exceptions, to be sure, but mostly those just prove the rule — as the saying goes.
No, most small space companies will have a “countable” number of customers or potential customers. The Founder will almost certainly know each of those customers by name and will have, or will be trying to have, a relationship with each of them.
And that is why we need to talk about the concept of the right kind of customer. Because the situation facing many space businesses is going to be that they have built a business model and investor expectations around being able to grow and scale into a large market. But the pathway to that market is going to have to be built, literally, one customer at a time.
Thus, finding the right kind of customer is going to be critical to the success of the business. In the last article I briefly described what the ideal customer looks like. Essentially, the “Right Customers” are those that conform to the idealized average customer that makes up the market. But since there actually aren’t any of those, it’s maybe more instructive to talk about how customers can be the wrong kind of customer and what effect they can have on a business, as it develops.
The first of these is what I would call “The Distraction.” This is a customer that businesses often meet early in their development. This customer is willing to pay for something that the company does that is NOT its final product. Often this is a service that is based on the IP that the company owns – often focused on the knowledge or ability of the founder. Sometimes it is an interim product — or maybe even a byproduct of the development process. Effectively, the company has discovered something that is of value in some way, but not central to the problem it set out to solve, or the market it set out to address.
In this scenario, The Distraction offers to pay cash for access to this interim product or service. They don’t want the company’s finished product. But they do want to pay cash. Right Now.
This arrangement will be particularly attractive to companies with a capital intensive business model who have not completed development of their product. Such an arrangement provides much needed cash that does not have to come through debt or equity. It is the very epitome of “non-dilutive funding.” Everyone likes a good boat of non-dilutive funding!
Often the issue actually begins to appear if the company is particularly successful in this first deal. Perhaps the initial customer expresses interest in giving the company more of this kind of work. Maybe a lot more. Or maybe the company discovers that there are other customers who might also pay for this kind of work. It’s not what the company wants to do in the long term. But it is paying some bills. Pretty soon, the company may be convincing itself that it can finance the business it really wants to be in, by engaging, at least for a while, in a business it never wanted to be in at all.
This is probably a mistake.
The fact of the matter is that being successful and competitive in almost any line of business requires focus and commitment. Engaging in any business as a sort of hobby that funds “the real business,” is almost always a recipe for doing one, or both, things badly. Almost invariably when this strategy is tried it results in one of two outcomes. Either the new business increasingly becomes the true focus of the company (and the Founder) and the original business model becomes the hobby. A hobby that sucks up all the profits and cash generated by the new business.
Or the new line of business limps along, in the normal course of events effort increases and margins decrease until the new business is not really making a net contribution. Instead, it is using up resources and, critically, the founder’s time and energy that would be more effectively spent getting the main business up and running.
In short, this kind of arrangement almost always becomes a distraction one way or another. This is not to say that companies should not be alive to the possibility of securing “non-dilutive funding” wherever they can. The trick is avoiding being seduced by the idea that there is easy money to be made doing something “on the side.”
This is also not to say that businesses that discover that they can already do something of real value for customers (even if it wasn’t what they thought it would be) should not pause and consider whether that is business they want to be in. Maybe a pivot to a new business model is in order. No one said that the original business model is written in stone. But, if the business has investors that are, literally, invested in that original business model it is not a transition that can be taken lightly. And it is not a transition that can be made in half-measures.
The second kind of customer that often appears in the life of a small company is “The Demanding Customer.” This is a customer that really likes the company’s product. Or rather, they like what the company’s product could be. Once it has been customized to meet their specific and detailed needs.
The issue of course is that the customization demanded is often relevant only to that customer. It may not even be about the nature of the product and more about the processes the Company must adopt in order to satisfy the customer.
Now, often The Demanding Customer is a large organization. Making this customer happy holds out the real possibility of more, maybe much more, business. Usually, the startup will be more than happy to engage in the required customization for the prospect of securing the future work. For a time, everyone is happy.
The problem is that if The Demanding Customer is also a Low Margin Customer it means that while the work to adapt the product or process generates revenue, maybe even significant revenue, it does not generate very much cash to reinvest to continue to develop the product or build the company to serve a wider Market. In this case, the company’s future will be increasingly dependent on the business, and good will, of The Demanding Customer. In this case, the company’s TAM shrinks until it is pretty much limited to the Market represented by that single customer. Once again, this may actually be a successful strategy for some businesses and some Founders. But it is very unlikely to be a strategy that satisfies the 50x VC Equation.
The final kind of customer that may be very attractive but may have significant market limiting potential is The Development Partner. This is a customer that offers to fund the development of the company’s technology or a significant piece of needed intellectual property directly and fully. The catch is that since they will provide the funding, the customer demands that they either own the new intellectual property, or at the very least, have some rights to control how it is used.
Once again, in the short term, this may be a very attractive arrangement for a company that is struggling to find ways to fund the development and deployment of their products. However, such an arrangement sows the seeds for difficulties down the road since it means that in return for what looks like “non-dilutive funding”, the company has actually suffered significant dilution. In this case, the dilution is not to the Founder’s equity, but rather it is dilution in the company’s ability to control and deploy its IP.
This particular problem with The Development Partner also makes them a Demanding and Low Margin Customer. In this case, the Development Partner will have the ability to use its interest in the founder’s company intellectual property to influence, or flat out, direct the company strategy for its own benefit. Again, while this may also benefit the startup — at least for some time —the customer’s interests will almost certainly NOT be aligned with moving towards a wider market and ultimately satisfying the 50x VC Equation.
The point here is not that any of these customers are bad. They may not even be the wrong customer for some businesses. BUT they will all, eventually, seriously limit the startup company’s ability to scale up and develop towards being able to serve a wider market.
For a company that has investors, or expects to need more investment, this can be a serious issue. As we have discussed, investors are attracted to a company’s ability to grow and often to grow aggressively. All of the customers described above will, in one way or another, interfere with a company’s ability to achieve such growth. To that extent these growth limiting customers will make the company less attractive to new investors and they will certainly make the founder less popular with the current investors.
By the way, the astute among you will also recognize that there is one place that all three types of customers can be found and often all at the same time…and that is The Government.
Which will bring us to the next and last installment in this series where we’ll talk a bit about how to find ways to ensure that the statements “I’m from the government” and “I’m here to help,” are not ACTUALLY mutually exclusive in An Entrepreneurial Space.
Editor’s note: This is the fifth article in a six part series focused on entrepreneurial space.