What follows builds upon my previous post, Fixing the VC Industry, and will act as a foundation for future posts. The conversation that my last post generated was incredible. I’m humbled and inspired by the kind words and the amount of interest it generated. Thank you.
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The life of a start-up, from brilliant thought to the point where the company scales (thus ending the “start-up” period of the company), consists of three distinct periods. In each period, the start-up finds itself requiring different help and support from VCs. An innovative venture capitalist can obtain a competitive advantage by providing the start-up, in the first two stages, with assistance that doesn’t come from traditional VCs. The third stage mainly requires ‘traditional’ VC services (access to large funds, …) and offers less opportunity for innovation.

Stage 1
Innovation: Incubating Ideas

Innovation, from the perspective of a start-up, consists of two phases and starts with a brainwave, kicking off Phase I innovation, and ends with a product, signaling the conclusion of Phase II innovation.

Phase I innovation is the process of taking that something that wakes you up in the middle of the night – a moment of insight, a brainwave, … – and turning it into a well rounded idea. Phase II innovation is the process of taking the idea and turning it into a product.

Innovative thoughts and great ideas are not a scarce commodity. Brilliant people have brilliant thoughts all of the time. The cost to the entrepreneur, in Phase I innovation, is time – time to fully think through a thought. This step rarely limits innovation.

Innovation starts to become limited when the entrepreneur is asked to spend more than just their time. Phase II innovation generally requires money to develop the product and this is the step that limits innovation.

Unfortunately for the entrepreneur, this is the time when raising funds is the most “expensive”. In terms of the cost of exchanging their currency (ownership) for what they need (money) the entrepreneur will never find a more expensive time. I briefly touched on this idea in my “Less & More” post:

Less Initial Funding. The business plan is untested, the market is unproven. Is money ever more expensive?

The aim during this stage should be to help the entrepreneur decrease the amount of money that will be needed. There has been an attempt to “fix” this innovation roadblock over the past few years: Incubators.

A VC not happy simply being an ATM should create an incubation-like atmosphere to help support the innovation.

There is a lot of assistance that the entrepreneur could use during this period and creating an incubation-like atmosphere is probably the best way for a VC to structure the support network. Let’s examine a number of services that the VC could (should?) provide:

IT: There is a true cost (time and money) associated with setting up the proper IT infrastructure. Having an infrastructure in place and simply allowing the entrepreneur access to it helps lower the cost.

Graphic Design: As the product develops the start-up needs to establish a corporate identity. Finding the right way to communicate with graphic designers is a task and takes time. Having someone who can be a conduit between the entrepreneur and the graphic design company will definitely speed up the process, and the relationship will help depress costs.

Bookkeeping/Accounting: The entrepreneur should not spend time sorting the receipts stuffed in the shoebox. The entrepreneur can’t justify a high priced accountant, but would surly benefit by having access to one.

Engineering support, relationships with machine shops, IP support, R&D tax credit expertise, and on and on and on. This is by no means even close to a complete list of services that an incubator-like atmosphere could offer an entrepreneur. The benefits are huge. Too huge to ignore. This idea is already being practiced and will only increase in occurrence in the years to come.

These incubator-like services add incredible value to a start-up. They significantly lower the requirement for funds at a time when raising cash is the most expensive. They also take tedious but necessary tasks away from the entrepreneur – allowing him/her to focus exclusively on the most important thing during this stage… creating an incredible product.

Once the product is made - and is believed to be incredible - the start-up enters the next stage.

Stage 2
Commercialization: Providing Proof

With a newly complete product many would argue it’s time to scale. It’s not. It’s time to validate. This stage is about proving value propositions, ironing out positioning statements, and figuring out the right foothold to use for market penetration.

Why? Because of the high level of uncertainty it’s expensive to fund the company at this point. An innovative VC should help the entrepreneur (and their investment) by helping to lower the price of money. This can be done by validating value statements, finding initial product users, and locating the correct penetration point. An entrepreneur doesn’t have the skills, resources, or time to successfully complete these tasks, but a VC team does.

Prior to scaling it’s critical to test the various value propositions on potential (small) customers. The testing of value propositions will help find and refine the best one. This will mean that when it’s time to scale, the product is launched with its best benefit(s) forward. It’s crucial that the testing of the various value propositions occur on small customers because the cost of screwing up potential future business – if the tested value proposition is wrong - is small.

This is where a lot of entrepreneurs fall into the faulty logic of: “Why are we focusing on small_company? We should be spending all of our time on large_company. Small_company isn’t worth our time, we need the home run”.

You can swing for the fences and miss. You can chase good money after bad and buy yourself another trip to the plate. And you can swing for the fences and miss again.

Why not load the bases with a number of small singles and then hit the grand slam?

That’s what validating the value proposition is all about.

Finding the foothold is different, yet equally important. When the product launches it needs a group of customers to give it some traction. Why leave it up to the customers to search the product out when it scales?

Here’s what I mean: there are products that are launched and then languish. After some time a small group of customers start using the product in a unique way, getting (potentially different) value from it, and this new market segment causes the product to become a success. Why leave this “discovery”, by what should have been the proper market segment, up to chance? Don’t. Go out and identify that small group of users in the right market segment.

This group of users will be the foothold market. It may be an entirely different group than first thought of when the initial brainwave occurred. But the right value proposition(s) have now been identified and there will be a market segment that will benefit greatly from one of the value propositions. Identifying the proper market segment will help lower the price of money.

What can an innovative VC do to help in this stage? Lots. This is where a VC team that is filled with skilled players, from a number of disciplines, can really create a competitive advantage.

First of all, there is significant skill behind identifying potential value propositions, testing them out with potential customers, outlining possible foothold markets, and validating these hypotheses. A VC team, doing this on a regular basis, can develop an expertise at these processes (practice makes perfect) and can assist, or lead, the entrepreneur through these steps. Also, this is where the VCs rolodex becomes very handy. Testing out value statements on friendly small businesses is much better than testing out value statements on random small businesses. The VC can mine their rolodex and leverage it to produce friendly test sites.

Second of all, this is the stage where the company would benefit from various experts assuming roles within the company for short periods of time. A diverse VC team could, uniquely, parachute support in for a temporary basis and provide world-class skill at a time when the start-up needs it but can’t justify it.

Part of “providing proof” is creating financial forecasts that are as accurate as possible. The start-up better not have a CFO at this stage, but an individual with CFO skills would definitely add value. The VC team could provide a CFO-like individual on an as-needed basis. 2 hours a week. 2 weeks. 2 months. Whatever is necessary.

The same is true of high-level managers, skilled operations individuals, and marketers. The company can’t justify hiring world-class experts in these roles but would benefit by having access to one. The innovative VC team can provide this team of support and earn a competitive advantage.

After identifying the right foothold segment and the proper value statements, the company is ready to scale – the price of money is falling. Lots has been proven, and the VC has provided key support along the way.

Stage 3
Scale: Making Money

You’ve created a beautiful product, you’ve proven its value and validated the market size. Now is the time to scale. This is the stage when it’s time “to make boatloads of money”. My brief comment from my “LESS & MORE” post sums up this stage nicely:

More Funding Later on. You’ve tested your business plan. You’ve proven your market. Will money ever be less expensive?

This is where the ‘traditional’ VC comes in. They’ve spent the post bubble years raising funds that are atrociously large. They’re looking to make incredibly large investments. They need to – the size of their fund dictates this. These are the people to go to when it’s time to scale.

To scale fast, efficiently, and with the required capital the venture is going to need significant cash. Sounds like a match made in heaven. The cost to the entrepreneur and the early venture capitalists? Very little, thanks to the commercialization stage. With a proven product, value, and market the start-up will find that this is the cheapest stage - equity exchanged for cash – of the process.

And isn’t that what the goal should be? Raise the most cash not only when it’s the most needed, but when it’s the cheapest.

Two of the three stages provide areas where an innovative VC can uniquely offer support to the entrepreneur. And this support helps the start-up out when it reaches the third stage and needs to raise the largest amount of money from the traditional venture capitalists. By offering a diversified support team to the entrepreneur and assisting with the commercialization phase, the VC can disrupt the traditional players and gain a significant competitive advantage.

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