Since exiting out of my various companies, I’ve been investing in tech businesses.
One type of company I’ve avoided investing in is those that use the ubiquitous ‘hockey stick’ graphs to tell their story of growth (which founders have learned to add from PitchDeck 101 class).
Trade Me’s Mike O’Donnell recently wrote a piece outlining ‘dumb’ questions to ask smart people, before you give them your money. It inspired me to reflect on why I choose to invest or not.
So how can one tell the difference between a good investment vs a bad one when presented with two similarly good looking forecasts?
Well, I’ve learned a few lessons the hard way over the years (Wynyard, I’m looking at you) and I’d like to share them with you. I’m sure some of you have your own rules of investing and I’d love to hear them – you have to discover your own investing personality over time. It’s a fun exercise of introspection and don’t discount the emotional, human side of what’s important to you to invest in. For example, I don’t invest in anything I don’t perceive to be good for the world.
TL/DR: Nothing beats asking the right questions and saying ‘no’ when you don’t get the right answers. Move on to the next pitch. There will be plenty more to look at.
First of all, there is no guarantee of success. Shit happens and even the most bullet-proof sounding strategy from high-quality founders can come unstuck in the face of environmental forces outside their control. However, you can give yourself the best possible chance of success by following some simple rules.
Rule 1. Understand how the company operates
How does it make its money? What is the company strategy on a page? This is such an important question for you to understand as an investor. Listen carefully to the answer you get. If the answer goes on about how much the company makes, or will make in future, or confuses you…stop now, put the pitch deck down, move on. There’s a reason why this is rule one: Investing in a company is about making returns. If you can’t understand how a company makes money but you invest anyway, do yourself a favour and be at peace to call it what it is: a donation.
Rule 2. Understand why the company is asking for investment
Is this the first round? When was the last round? Is the money still in the ‘system’? Ask to see the previous rounds pitch decks and ask if the targets were met. Listen carefully for excuses for not meeting targets. Was it always someone/thing else’s fault? If a company is constantly raising cash but showing little user or customer growth, do yourself a favour and buy a truckload of delicious Lewis Road Creamery artisan ice cream instead with your cash. Though you may equally regret the long-term outcome, you’ll get more noticeable growth and you’ll love every interaction with your investment along the way. Except perhaps the growth.
Rule 3. Understand the market
How big is the market? What validation has the company done to find out? Does the company have a plan? Is the timing right to address this market? Listen carefully for specific answers and good market validation analyses.
If the founder talks about the ‘global market’ when they’re barely large enough to sell and manage half a dozen local customers, start the timer. If they talk big numbers but have little validation documents, ask them why. Validation can be hard to do in some circumstances but it must be done. Otherwise validation will be done the hard way – with investors cash burn and no customer sales cashflow. I learned this the hard way when I co-founded a non-alcoholic liquor company well before there was much market interest in such a product. I had mistaken my personal friends and acquaintances bubble (made up of lots of bartenders) for customer demand.
Rule 4. Understand why customers are buying
Who is the target customer and why? How well does the company know it’s target customer? How many customer segments exist that would rate the problem solved by the company a top 3 ‘must solve’ problem? Can they prove it? Does the company understand the customers buying cycle?
Listen carefully for companies that have little or no expertise in their target customer field and have done little customer empathy research. Don’t even go near a company that says ‘we sell to everyone’. Use the cash to buy someone you love a gift from The Good Registry instead. Because no customer likes buying products they don’t need and no one likes getting gifts they don’t want.
Rule 5. Understand the founders and management team
What is the background of the founder(s)? Have they come from the industry sector their product/service is selling into? What about the management team capabilities and experience – what is it, and why were they hired by the founder? Do they actually know what they’re talking about?
Listen carefully for inherent bias in products/services in companies founded by someone from the industry they are serving. “I am my own customer”. While this can be a great strength – it can also be a source of stubbornness. Also, listen for statements full of buzzwords but not informed by research data or specific experience. Is the founder learning? Coachable? or are they too consumed with their own joy juice?
Rule 6. Understand the product and/or service
What is the product/service? Who are the competitors in this space? Why is this product/service better than the competition’s? How hard is it to replicate? How do customers currently solve the problem this product/service seeks to solve and how easy is it for the customer to convert over? What does the onboarding process look like – how long does it take, how costly is it, how is ‘trust’ built with the customer, and how many leaps of faith are required by the customer along the way to acquire them?
Listen for glossed over answers that quickly go to ‘How [innovative/disruptive/game changing] the product/service is’. In my experience, those are foreshadowing words for ‘This company is going to spend a lot of investor cash on educating the market’.
Understanding the competitive dynamics is crucial – simply having a good product/service is not enough.
Rule 7. Understand the people and culture
What, if any people and culture strategies exist in the company? Is there a clearly articulated set of values and culture? Do the founders/company leadership embody this in their actions and how? What is the current staff attrition rate – how often has the company had to restructure? How does the company bring the customer voice into the day to day operations of the company – how does the company ensure this is well understood by staff?
Many of us have heard the adage “culture eats strategy for breakfast”. Whilst the line is often taken out of context, many companies focus too much on ‘product/service’ and ‘strategy’ and not enough on the third critical element that makes a successful company: great people. This is partly about recruitment, partly about induction, partly about retention. Understanding the company plans for recruitment and retention is as important for an investor as is understanding the finances. Continuous restructuring and high attrition rates in critical growth roles in the company is ‘the canary in the coal mine’ for future company performance – unless specifically addressed well during the pitch, investors should run a mile. Listen for mentions of culture and values – ask for written examples that have gone to staff. Watch for broad brush statements of “high performance culture”.
Rule 8. Understand the governance
Is there a Board in place? Who are the advisors to the company? How/why were they chosen? How often do they meet and what influence do they actually have on company strategy? What has been their success track record with other companies? Is there enough diversity of thinking inputting into the company?
Good governance is one of the most important ingredients for company success. Be wary of board directors who sit on too many Boards, who do not have recent company success, do not have influence on company direction and are there for ‘transactional’ reasons. For example, they’re a partner of an accountancy firm who provide accountancy services to the company.
Be observant of the composition of the Board – if they are stale, male and pale, your investment returns are also likely to be stale and pale. Listen carefully for founders talking up the credentials of the Board rather than ‘what and how they actually contribute and how they influence direction’.
Rule 9. Be passionate about what you’re investing in
Do you genuinely care about the company you’re investing in (beyond caring about returns)? Are they supplying a product/service that addresses a pain point you are really passionate about? Is the company management/board passionate about solving this problem too or are they more interested in making money?
I once got involved with a company whose founder kept telling me about the amount of money the company is going to make (hockey sticks!) but was never authentic in articulating their passion for the customer pain they were solving. This was all the more stark in that their product literally had the potential to save lives! This is the emotional side of investing that you shouldn’t discount. Investing in startups/scaleups requires a steel stomach – it is going to get rough out there. Ups and downs are normal. Your willingness to ride these waves is much easier if you’re personally invested in the solution as much as the company is.
What do you think about my rules for investing? Do you have any of your own?