Due diligence for the entrepreneur

The question I’m most frequently asked (and most frequently ask myself) is how to validate and size business opportunities. Is a particular start-up or concept the next Google or doomed for failure?

I’m rather lucky. I’ve been able to spend the past year or so acting as entrepreneur, angel investor and early stage VC at various times. I think one’s process depends on whether you’re an investor building a portfolio of bets, or an early employee or founder with a portfolio of one.

First the similarities …

Evaluating businesses at its most fundamental level is really an exercise in understanding, measuring and trying to minimize risk. I’ve often said that entrepreneurship is like having 10 playing cards all face down, with the goal to turn as many over as quickly and cheaply as possible. It doesn’t matter if you’re an investor, entrepreneur or thinking of joining a young company.

In all cases, one must assess the ability to raise investment from quality investors. Capital is the venture’s fuel and the fuel has to be high quality and most importantly, you don’t want it to run out. Additionally, it’s important to feel that you’re being rewarded for the risk – the equity received should correspond to the level of risk in the venture. This can be hard to quantify, but there are some rules of thumb that experienced entrepreneurs and VCs use. Trading off some amount of equity for lower risk is generally a good idea given that the nature of start-ups is inherently risky.

Market size is also important, but can be elusive. Simply put, the venture should be attacking a hard and large problem. All ventures are hard, so if you’re going to invest money or “sweat equity,” you better be going after a significant opportunity and not an incremental innovation. I gain comfort by talking with folks in the target industry and making sure their eyes light up when I talk about what I’m doing.

People. So much of the success of a start-up comes down to the team. Does the team have a track record of success? Does everyone bring different skill sets? Does the team have good chemistry?

And the differences …

Time. My experience having founded 2 companies is that it can take many months (or more) to validate a business plan. An investor or employee can make a decision in a week with only a few calls, but the entrepreneur should make at least ten times as many calls. The entrepreneur needs to become an expert in the field in which he/she is thinking of entering.

As an investor, you can rely to some extent on other’s research. As an entrepreneur, you have to do all of your own research. You should hear directly from end customers. You also need to candidly assess whether your previous experience and your own skill set enables you to be uniquely valuable to the venture. In essence, you should feel as though joining the company improves its probability of success.

Finally, there’s the big intangible difference between investing and operating. As the operator, you have to wake up every morning and spend all day working on a single cause. To be successful, you have to believe in the mission. Without passion, it’s not worth it. Like much of life, wait for your spot. But when you find it, jump in with both feet.

5 thoughts on “Due diligence for the entrepreneur

  1. Interesting post Micah – thank you for sharing the insights from both sides of the equation. One additional difference I’d love for you to address between the entrepreneur and the investor is the amount of energy focused on problems of different time dimensions. What I mean is that the entrepreneur has to find that elusive balance between the immediate – get a quote out, service a customer, hire a team member, etc – and the long term strategy. The investor will clearly spend much more of his/her energy on the long term strategy. The challenge for the entrepreneur is to make the strategy evident in the operations – to manifest the vision in the focus and actions. Not sure what the equivalent balance is for the investor.Thoughts?Adam

  2. Adam, as you state, I think its a tough balance. I think the operator has his/her eye on execution. For example, I suspect Bezos was very focused on making the buying process for books as robust and consumer-friendly as possible. Think 1-click shopping. I also suspect, however, that from the beginning he was thinking beyond books and telling his investors and others about the big vision … of becoming the largest e-retailer. My colleague Eric likes to say "eyes way up to the sky, feet firmly planted on the ground." An operator who runs a tight ship, but has an eye toward a bigger vision is ideal from the investor standpoint and for building a large, scalable business.

  3. Micah, good post as usual. I’m not sure I agree with you that the entrepreneur’s job is to minimize risk. I think his/her job is to try to find a way to create obvious and sustainable value on behalf of one or more parties where that value can be traded directly or indirectly for money. The best business models are those where value increases disproportionately with scale. The starting point is an area where there is a large amount of potential value. But it may take a lot of time and include a lot of execution risk to figure out exactly how to extract that value. Inherent in a VC’s methodology should be risk mitigation and management techniques.

  4. Estimating a market size is at best a black art. I think it’s more of an MBA study than something anyone cares about in real terms. However, there is always possibility that a market is simply too small for anyone to pursue. But don’t focus on the exact, you’ll always be off by an order of magnitude.Jimhttp://www.neocontext.comBlog at: http://blog.neocontext.com

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