A meeting with an entrepreneur last Friday reminded me of the most frustrating and overused feedback entrepreneurs receive from VCs:
Talk to me when you have “momentum”; or
I need to see some “traction” first.
With more and more VCs looking to make later stage investments, entrepreneurs are receiving this feedback more than ever. You can understand why an entrepreneur might find this feedback frustrating. If they had massive traction, they probably wouldn’t need VC money, or if they did, the deal should be priced at a much higher valuation. That said, the real issue with this feedback is that it triggers a conversation about the definition of momentum. Entrepreneurs complain (rightly so I might add) that the VC definition of momentum comes in the following forms: 1) VC defines momentum by saying; “I know it when I see it”, 2) VC gives a milestone as a proxy for momentum that if achieved means that the entrepreneur will no longer need capital, or 3) VC gives a milestone but moves the goalposts once the milestone is achieved. Fundamentally, these are all non-answers and don’t serve the entrepreneur particularly well.
I’ve tried to take a different approach. I’m not smart enough to define momentum for every business, so I don’t bother trying. In-stead, I try to work with the entrepreneur to describe the value creation engine of the business; the mechanics through which value is created. With those mechanics defined, investors will get excited about just about any business for which the process of igniting that valuation creation engine is both replicable and scalable. I lay it out as follows.
Identify the value creation engine for your business
Generically speaking, the value creation engine links the time, energy and capital you invest in the business to the measure of output that you think will be used to value the business at exit. The measure of output you choose depends on the type of business you are building. If your business is about aggregating eyeballs and monetizing them, then you will likely be valued based on unique visitors, users, user engagement, and the “potential” monetization of the audience. For more mundane businesses, your value creation engine may be revenue generation and eventually your ability to generate profits. If you can’t articulate the linkage between time, energy and capital and the value creating output of measure for your business, then you haven’t figured out your value creating engine. For example, wouldn’t it be great to say:
Based on experience thus far, a new account rep. will begin producing between $5k and $10 of incremental monthly recurring revenue within six months of their data of hire.
Make the value creation process replicable
Understanding your value creating engine implies that there is both a process in place to create value and a causal relationship between time, energy and capital and the desired measurable outcome. If there is causation, then the process for creating value is likely replicable; if I do X, then Y. If I do X again, then Y again.
When something is replicable, a measure of control is implied. For my part, I like businesses where the company is in control of X; more sales people, more marketing, more channels, etc. Businesses that rely on “viral” effects where the company has little control over the creation or velocity of the viral process are more difficult for me to get my head wrapped around. If I can’t control X, why should I believe X will continue to turn into Y?
Show that the process is scalable
Some value creation processes have rapidly diminishing productivity curves. The more input you give the process, the less productive the process is in generating output per unit of input. What I’m looking for is a value creation process where I can add a significant amount of additional time, effort and capital as raw material without diminishing the returns on investment; that is scalable. If I add five more sales people, I generate 5 times more leads, which turn into five times more sales, etc. You don’t have to prove this, but you should be able to make a compelling argument for why the process is scalable. A really big market with lots of customer prospects really helps. I’m more likely to believe your valuation creation engine scales in a big market than in a small one.
Entrepreneurs should not be deluded into thinking that there is some magic threshold number that once crossed will enable you to raise huge sums of money. Businesses that have a replicable and scalable value creation process make for attractive investments because additional capital is fuel on a fire that is already lit. In a market where investors are more risk averse than ever, these businesses are the ones most likely to capture the attention and imagination of investors.