Letter From An Angel Investor To An Aspiring Founder

Dear Jane Founder,

You, the aspiring entrepreneur, walk into my office to pitch your idea. You think that you have invented a new way to turn lead into gold. My job  is to distinguish between the few great ideas and the many lousy ideas that I see day in and day out.

Image by Camera Press via The Daily Mail

Let me explain: Early stage investors such as myself are willing to take on a high risk investment to achieve commensurate returns. As such, I am looking to invest in early stage founders and their startups. I am cognizant that, at this early stage, my ability to judge is complicated by a lack of product validation. A Minimum Viable Product would certainly reduce my investment risk, but it would also reduce my expected returns. And in fact, early usage, revenue, and ‘traction’ are no guarantors for later success.

In the absence of that early validation, there are four inquiries which help me assess the quality of your idea and of your thinking. Before you have even built a prototype.

Image by Salon.com

1. What problem and whose problem are you solving?
   
   You listen to the customer, and you clearly understand the customer’s main problem and the viability of the existing solution. You know the single performance measure that is most important for the customer. ‘ Because customers don’t care about your idea. … We tend to fall in love with our ideas, but you need to test your ideas. Do your customers want your value proposition?’
   
   You have identified the customer segment with the most urgent need to have the problem solved.
   
   

Image by TheBestYou.co

2. What is special about your idea, and how are you planning to validate it?
   
   Having contrarian ideas is hard. I am looking for ideas that are non-consensus to produce outsize return. To quote Howard Marks: ‘To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.’ Peter Thiel is asking whether you have a secret, an important truth that very few people agree with you.
   
   Chris Dixon has characteristized the best ideas as (a) powerful people dismiss them as toys; (b) they unbundle functions done by others; (c) they often start off as hobbies and/or (d) they often challenge social norms. Paul Graham has stated that ‘the best ideas look initially like bad ideas’.
   
   I check my own biases for overlooking contrarian ideas by using diagnostic questions such as ‘Isn’t this a niche play? Is this just an ‘interesting’ investment? What do you do again? What do you want to be when you grow up?’
   
   You have solicited as much feedback on your idea as possible. Ideas, even before you build a product, need to be tested. If an idea remains a secret it simply means that is lacking validation. Even Einstein didn’t come up with the Special Theory of Relativity all by himself.
   
   You have identified the right user, and have talked to enough of them. You have A/B tested to target the right audience. You have confirmed that the problem to be solved is relevant and urgent for the user. You have validated the solution by understanding the user through precise observation and user feedback. You can answer Sequoia Capital’s question Why now?
   You can do all of this with a simple storyboard before a single line of code is written. Y Combinator makes the team walk through every step of the idea first, and only then convert it into a product.
   

Image  via Boldmode.wordpress.com

3. What market are you going after?
   
   Winning founders find great markets.
   
   Now that you already understand your target customer, you understand the market you are in. Andy Rachleff has suggested that the market always wins: ‘When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins.’
   
   You understand whether your idea addresses an existing market - the code words to look out for are ‘better mousetrap’ and ‘continuous innovation’ - or whether you are addressing new buying segments and are creating a new market - ‘disruptive innovation’. Understanding the category where the startup fits and who are the leaders in that category is crucial. Paul Martino from Bullpen Capital says, ‘There’s an advantage of investing in nascent markets and backing something before it becomes obvious to others.’
   
   Your startup should introduce the customer to a new category of product or service. Ann Miura-Ko from Floodgate invests in category kings, in those startups who define their category: ‘What is the category where this fits? Is it a category worth winning? Is it a category where the startup can become king?’
   
   For existing markets, you understand the different dimensions such as: How big is the market globally? Are there any dynamics that will change it? How much of the market can you serve? How much of the market can you get?  What stops the incumbents from copying your idea? What would you do if you were competing with yourself? Y Combinator’s application is asking ‘What do you understand about your business that other companies in it just don’t get?’
   
   Understanding the addressable market is about making choices: ‘[...] you have to compromise on one dimension: you can either build something a large number of people want a small amount, or something a small number of people want a large amount. Choose the latter.’
   

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4. How are you going to make money?
   
   You have validated a price range by talking with customers. You find creative ways to prove that you deliver value to the user and can make money even before an MVP. Coin created a simple web page where people could order and pay even before Coin had a product. They reached their $50,000 pre-order goal in just 40 minutes. If your product is not web based, you have tested pricing assumptions in repeated conversations with potential customers.
   

Ultimately, I am asking all these questions for one reason only: What is your level of insight? It’s okay if you don’t have all the answers, but I expect that you have clearly thought about the known knowns, known unknowns, and the unknown unknowns. Only then will I listen further when you talk about traction, team, funding, product, channels, revenue and cost.

With warm regards

Your angel investors

Christian Dahlen & Oana Olteanu

The Myth Of The Founder Who Could Be Replaced Early On

It is not uncommon for venture capitalists to replace a startup founder with an experienced CEO. Typically this happens during the rapid growth phase in the startups life when the original founder does not ‘scale’ to manage the larger business.

Disconnecting ideas and founders may succeed after initial viability and desirability have been proven. But replacing a founder before achieving product/market fit (PMF) leads to disaster. If the initial idea is just average, the absence of a great founder almost certainly ensures that improving on the initial idea will not happen. Handing over the idea to a hired manager results in the well studied principal - agent problem.

The two archetypical examples where investors have uncoupled ideas and founders before product/market fit have resulted in below average returns

• In the 1990s, venture capitalists funded ideas irrespective of founders. Management consultants produced reams of powerpoint decks for new startup ideas, and investors went on a binge to found these ideas.  

• At large companies, new ideas which originate from one inventor are often handed over to another team to execute before product market fit has been achieved. Except for incremental innovations, the typical outcome has been business failure and has been well researched and documented in the Innovator’s Dilemma.

Theoretically, an investor could bet on the initial idea and on the market at the expense of the team, subscribing to the hypothesis that great markets always win.

I don’t know of any examples when this worked in practice. Do you?

2 Things Albert Einstein Taught Us About Ideas

In today’s world, the cost of validating the desirability and viability of an idea have dramatically decreased. Kickstarter has become de rigeur for funding new hardware ideas. The proliferation of open source software has made building applications easier and cheaper. Venture capital firms and and service providers such as Mattermark and CBInsights have heavily invested in analyzing the many readily available signals to identify future unicorn startups early on.

As those signals proliferate and become transparent, professional investors will quickly coalesce around consensus good ideas, angel investors will have to focus even more on the earliest pre seed stages where transparency is low, metrics are not available, and the entrepreneur only has an idea. A Minimum Viable Product may not exist yet and the team is in the problem/solution validation stage, at best. In fact, angel investing and the skill sets required from angel investors may return to where they were in the 20th century.

The two people in the picture above illustrate that this is not an entirely new challenge. In 1905, Max Planck was a 47 year old physics professor in Germany. Albert Einstein was a 26 year old assistant patent examiner in Switzerland. He had previously published five papers in the field of thermodynamics and was virtually unknown in the field of elementary physics and in academic research circles. In the same year and seemingly out of nowhere, he published four papers which revolutionized the world’s thinking about physics. Yet, the only experiments to prove any of his theses were ‘Gedankenexperimente’ - thought experiments. The questions which everyone in the field had to ask themselves at the time were 'Is the author trustworthy?' and 'Are the ideas valid?' Planck was very much in the position of an angel investor having to assess whether there was any credibility to the idea and the idea alone.

Dark horse founders without obvious track records emerge all the time.  Albert Einstein already observed that ‘anyone who has never made a mistake has never tried anything new’. Angel investors may have to make an investment decision solely based on the founder and their idea. They need to assess the qualities of a founding team and the right timing of founders and their ideas.

As Albert Einstein said: ‘If at first the idea is not absurd, then there is no hope for it'.

Thanks to Oana Olteanu for reading drafts.