Ideas and business models are what people usually think about when they hear the words startup and angel investing. What is the problem they are solving? What is the product? How will they make money?
We have previously looked at the general idea of this framework in “How To Spot Great Angel Investing Cases (Part 1)” and why it’s important to have a model. Then we took a closer look at the first factors Timing and Execution in the follow-up article: “How To Spot Great Angel Investing Cases (Part 2)”. If you have not already read those I suggest you start there as this is a continuation.
In this last article, we will be wrapping up this series by covering the factors of Idea, Business Model, and Funding. It has been shown that these are the least important factors for the success of a startup but they are non the less important too. The quality of the current hypothesis of the Idea and Business Model also says something about the team’s execution skills.
A hypothesis of the product offering and a way to make money
Let’s be clear about one thing though before we dive into the details. The fact that the Idea and the Business Model are less important than Timing and Execution does not mean a company can survive without them. What it means is that the product offering and the way of capitalizing on it will change over time for a startup. It’s called pivoting in the startup world.
For example, a team could claim they don’t need a business model and are aimlessly building “cool stuff” in a hot space like crypto or AI. The business model will emerge later. This is just poor execution. The team should be working with a hypothesis on their business model and proving or falsifying it. Basically, if they can not manage to come up with an idea on how to charge customers now, the chances are they never will.
The same thing goes for the Idea. The team needs to work with a hypothesis on the value they will provide to the customers. Otherwise, mark them down with a minus on the execution factor. If they are coachable and you see them having access to a great product person you could still explore the opportunity further, otherwise I suggest you run for the hills.
Idea – The problem to solve and its solution
Make sure the team is solving a real problem. Being an entrepreneur is a strange calling. You need to believe in your idea so strongly that you are not discouraged when speed bumps show up. Or critics, there are usually a lot of those. But at the same time, you need to listen to advice. It is actually quite a paradox.
When we talk about a real problem it means something people are prepared to pay money for. As Peter Thiel, co-founder of PayPal and early investor in Facebook puts it in his book “Zero to One: Notes on Startups, or How to Build the Future”, the idea needs to be 10x better than current solutions. Otherwise, it will not be able to overcome the inertia of current behaviors we talked about in Part 2.
Look at the anatomy of the idea. Both the product itself but also how it is to be produced and serviced to the customers. Look for signs of these attributes in the idea:
- People – If the idea requires a lot of people to produce and service the customers we should be careful. Especially if they are to be employed by the company. More people impose complexity on the system. They need to be managed and paid for. And when the number of people grows the complexity of the organization grows geometrically. Basically, the idea is not scalable. An example of people-intensive ideas would be professional services firms like consultancies.
- Capital – Capital can be great to apply leverage but generally, later-stage investors do not like to tie up large sums of cash for the production of services. We want our capital to go towards the growth of the company. Examples of capital-intensive ideas are ones that require investments in expensive machinery like building factories or buying property.
- Intellectual Property (IP) – Is the product hard to replicate? Maybe there is a patent or it requires a specific skill set almost unique to the team? Now it is getting interesting. The competition will not be as fierce and it will be easier to defend the business from competitors. Examples of ideas with high levels of IP are ideas coming out of universities and AI-oriented ideas based on large datasets that are hard to replicate. Deep tech companies often fall in this category. Strong brands also belong in this aspect.
- Network Orchestration – Products and services that give more value to the customer if there are more people using them are great ideas to build a startup on. The Network Effect effect comes into play. Imagine a dating service, social network, or marketplace to trade goods or services. They are all examples of network orchestrators. A result of this is also that the first network established in a field is hard to compete with. Look at what happened to Google+. Despite being backed by all the assets of Google they had to shut it down in 2019.
Business model – Translating value creation into money
This is ultimately what a venture is about. Making money. At least if it is a for-profit company. Willingness to pay for a product or service is the ultimate proof of the value you deliver.
There are a few main types of business models. B2B (Business to Business), and B2C (Business to Consumer) are the main ones. Then there is B2B2C which is when the company uses other companies to reach the end customers who are the consumers.
We can then apply different pricing models, packaging, go-to-market strategies, and so on. It’s quite a subject to go through so let’s focus on some key points, things to be aware of, and to look out for.
First of all, you want a service or product with a high gross margin when produced when you start scaling sales. It needs to be in the area of +80%. The gross margin is calculated by looking at the unit economics. This is an interesting read on the subject: “The Gross Margin Problem: Lessons for Tech-Enabled Startups”.
Notice what I said at the beginning of the last paragraph. “When you start scaling sales”. It’s ok not to have a great margin in the beginning. The team is exploring the value chain trying to find where it fits in. It’s costly but ok. But not as costly as blowing hundreds of thousands of SEK on ad campaigns with inferior margins.
Remember that a survey stating that X % of people would pay Y SEK for a service is not the same as they actually would do it. It’s only an indication. Make sure the team has really tried out the willingness to pay by charging real money.
Here are some key things to watch out for:
- Complicated ecosystems – When one organization/person needs the service but the budget sits with another organization/person. The further apart they are the worse it gets. This usually shows up when government organizations are involved somewhere like healthcare, public services, and so on.
- B2B products with small contract values – If they are able to automate the sales fully it is ok. But if they need manual work to take customers through the sales cycle and onboarding you should be careful. If these services are not priced at 500 TSEK / year or more they need to be super sticky for the cost of sales not to eat up all the margin.
- Non-recurring revenue models – You want to see the customer base grow over time once the company hits product-market fit. This will ensure smooth revenue growth. One example of a problematic revenue model is an advertising-based one. Some kind of subscription-based model is the best if customers are up for it.
- Freemium models with a small addressable market – Freemium model is quite common for SaaS services and a good way to build a customer base. Just remember that the conversion rate is often low. Even if you can get a decent number of people to start using the service regularly, seeing a conversion rate of free to paying above 10% is good. Getting to 20% is world-class. Do the math here to get an idea about potential revenue.
- Temporary need from the customers – A product the customer will stop using after a while for natural reasons is problematic. The startup will have to make up for the attrition of people not liking the product after trying it and then on top of that the people who liked it but no longer have a need. A tough challenge. Examples could be if the customers are kids in a certain age group, people with a non-chronic medical condition, or in a certain phase of life.
How can it be the case that the ability to make money is the second to least important factor? And does this mean you can disregard the lack of a business model when you evaluate potential investments? What you need to do here is to embrace uncertainty.
It’s ok for a startup in the pre-seed / seed stage to not have a validated business model. It’s what these phases are for. But what the team needs to have is a hypothesis for the business model. It can, and should, change when the team starts to tinker around and try things out.
If the team does not have a believable business model on which they are working on validating I would put that as a risk in the execution/team dimension. The risk that they will blow the funding money on the wrong activities is then really high.
Funding – Having enough resources to reach profitability
This is the least important factor. The nature of the market will usually solve the funding aspect on its own. If the startup has a strong driver for why it should happen now, is strong in execution capabilities with a great idea and a good business model there will be people willing to invest and the funding parts will be covered.
But with that said, a startup backed by a super-rich uncle willing to pour money over the founders will probably have a slightly higher chance of succeeding. The team can make more errors and maybe even not have to spend time on fundraising which is quite a time-consuming task and instead spend that time finding product-market fit and then scaling the business.
I guess the above scenario is more of a thought exercise than something that would happen in reality. In this aspect, I usually put it as a plus if there are strong backers with deep pockets. It will be easier to raise money in the future as they serve as an attractor for other investors and they are also more likely to put in more money themselves.
On the other hand, there could also be an argument made for it being a disadvantage of having backers with deep pockets.
The argument for this is the fact that having too many resources makes you less prone to build a product the customers actually want to pay for. I have seen this happen countless times in larger organizations where stakeholders are not interested in what the customers want but more about pushing their personal ideas to the market out of vanity.
It all boils down to the process used. There is nothing inherently bad with lots of resources. It will give you peace of mind to focus on building your product. But the team needs to be mindful of how they build the product. It’s like saying having access to an abundance of calories makes you automatically obese. It could if you don’t watch your habits.
Idea, Business Model, and Funding are the three last aspects laid in our framework presented in Part 1 of this series that can be used to assess angel investing opportunities. The first two aspects Timing and Execution was explained in detail in Part 2.
Look for businesses solving a real problem with a solution that can be defended against competitors. There should be a business model that is scalable, preferable with recurring revenue.
Good ideas are built around network orchestration and unique IP. Avoid people and capital-intensive operations.
Make sure to use a structured process to evaluate your potential cases. Write things down. It will force you to engage your logical thinking. Using a deal memo is an excellent way to do this. You can download the template I created for myself at the top of this article to get inspiration.