When I first began teaching entrepreneurial finance in 1996, I had a lot to learn. There was little rigorous data available at the time on the criteria used to evaluate business plans. That was a problem because I didn’t have a good understanding of how entrepreneurs could get funding, and how investors made investment decisions. And I was teaching this stuff.
Luckily, I was friendly with some local venture capitalists who let me sit in on days when companies would pitch their businesses in the hope of getting funding.
It was fascinating to see companies make the same mistake during their 45-minute pitch. The entrepreneurs would spend 40 of those minutes describing their product, solution, or team. It wasn’t until the last five minutes that they got around to talking about customers. Sometimes, by that point, it became clear that they had left that until the end because they didn’t have any customers. At other times, they miscalculated, spending their time talking about cool new technology, without addressing the most basic and important question: Will the company get customers, or, more colorfully, will the dogs eat the dog food?
While the drawbacks of some of the presentations were fairly clear, I wanted to understand in a more systematic way how venture capitalists decide whether or not to put money into a company. So I asked some of my VC contacts if I could see their investment memoranda, the internal, private documents in which the firms discuss why they decided to back certain businesses. I was able to get memoranda for investments in 70 companies by 11 VC firms. This gave me a good overview of the thinking in the industry across venture capitalists.
From these memos, I came up with a framework that I teach to this day (refined through a subsequent survey of more than 800 venture capitalists). For my students who are going to become investors, it helps them understand what venture capitalists actually do. For those who are on a path to becoming entrepreneurs, the framework helps them understand both how investors will evaluate them, and, perhaps more importantly, what chance their startup has of succeeding.
In essence, the framework is a series of questions that investors and entrepreneurs should ask themselves to evaluate companies and their chances of success. If, as an investor, you go through the framework and get negative answers, you should not invest. If you are a founder and you don’t have good responses to the questions in the framework, you either need to change your business to produce positive answers, or rethink the whole idea.
I call the framework OUTSIDE-IMPACTS, two acronyms that capture the key elements of each question. OUTSIDE stands for: Opportunity (which, as we’ll see, incorporates IMPACTS), Uncertainty, Team, Strategy, Investment, Deal, and Exit.
The first of these is about the business or opportunity, and it is here that IMPACTS comes into play. The essential question about opportunity is: Does the business idea create a positive expected value? To answer that requires evaluating its IMPACTS.
Can the founders explain the idea clearly and succinctly? Are they clear about what problem it solves? Have they established the “pain point”?
Is the target market large enough to support substantial growth or valuation? How large is the overall market? How large is the market segment the venture is targeting? Who are the key customers? How many are there? What will they spend? Is there solid support for these claims? Are there additional opportunities?
What exactly is proprietary about the idea? What is differentiating? Why will it make money? How will it make money? What is the “edge”? Does it have a first-mover advantage? Is there a potential network effect? Does it have an advantage in terms of switching costs, execution, or technology? Are its advantages defensible?
Will customers in that market accept or buy this new product or service? Who is the customer in the target segment? Why will the customers buy? What do they buy now? Why do they buy that? Why will they switch from their current product? How will the business reach the customers—through a direct salesforce, resellers, or distributors? Will it use advertising? How quickly will it get customers? Can it acquire customers and still make money? Can it retain customers and still make money?
Why won’t the value be competed away? What will existing competitors do? What will other new entrants do? How will the entrepreneur respond?
Why is this a good time to enter? Why hasn’t the opportunity been taken already?
How quickly can it be implemented?
For both founders and investors, this is a good point at which to take stock. I advise my students that if the opportunity does not have IMPACTS, it should not be pursued. But if the idea produces positive responses so far, there is still more road testing to be done. It’s time to advance to the rest of the OUTSIDE criteria.
Good investors and successful entrepreneurs keep track of the things they aren’t sure of. Many businesses fail because uncertainties turn out to be negatives. Being aware of the uncertainties and keeping track of them is important.
Companies, particularly startups, should always be trying to reduce the uncertainties, or move them in their direction. Managing risk means understanding the uncertainties involved in the venture and minimizing those that can be minimized. If you’re worried about customer acceptance, talk to more customers. If you’re worried about your management team, hire a better team.
That leads us neatly on to an in-depth evaluation of the team currently running the business. Some good questions to ask on this theme include:
- Can the management team implement the opportunity?
- How does their previous experience relate to the opportunity?
- How “hungry” are they?
Often, this analysis reveals that key elements of an effective management structure are missing, so it is worthwhile identifying:
- What pieces are missing?
- What type of person or people will you look for to fill them?
- How will you find that person or people?
The next question should be about strategy, which ties together everything we have analyzed so far.
The fundamental question here: Is the company’s strategy consistent with the opportunity it is pursuing, the uncertainties surrounding that opportunity, and the management team it has in place?
Next up is a deep dive into the company’s finances. Do their forecasts and cash-flow requirements make sense, and are they reasonable?
A popular phrase in the startup world is “cash is more important than your mother.” CIMITYM. Your business idea can succeed without your mother. It cannot succeed without cash. Many promising startups die by simply running out of money before they can prove they are viable.
Even if the business idea looks solid, to secure investment, it is critical that the deal be well structured. Some important questions to ask are:
- Does the deal structure provide appropriate incentives?
- Is the deal priced attractively?
- Do the key individuals have incentives in place to do the deal and to make it work?
- Does the deal structure provide or ensure appropriate governance?
- Does the deal structure help manage the uncertainties?
Being part of a successful new company is thrilling, but smart investors are focused on how to earn returns and how to cash out. It’s important even at the start of the process to think about whether investors can exit the deal, and how, and whether that part of the deal is priced attractively.
Why Grubhub succeeded and Bump failed
The OUTSIDE-IMPACTS framework performs well in practice. Consider the examples of Grubhub, the online food-delivery platform, and Bump, the technology that enables people to transfer information between mobile phones by bumping them together.
Both companies won the Edward L. Kaplan, ’71, New Venture Challenge, the startup competition at the University of Chicago Polsky Center for Entrepreneurship and Innovation, where I am the faculty director. Grubhub won in 2006, and Bump in 2009. On the back of that, both companies received funding from top-tier venture capitalists and a great deal of media attention.
Yet Grubhub has achieved stratospheric success—and a value of more than $6 billion, while Bump, which was acquired by Google in 2013, never fulfilled its potential. OUTSIDE-IMPACTS can help us understand why.
When Grubhub was measured against the framework, on every score, Grubhub was clearly a company with IMPACTS. Bump, by contrast, won the New Venture Challenge in spite of there being one big hole in its business plan: there was no revenue model. It did not have a well-defined market or a paying customer. It also was far from obvious that there was acceptance for the idea—at least in terms of people willing to pay. Bump received funding, but it never generated meaningful revenue from customers. The application of the framework revealed a big uncertainty in IMPACTS that was ultimately fatal.
Bump is just one example demonstrating that many VC investments end up not being successful. In fact, somewhere between one-half and two-thirds of VC investments have lost money historically. Investing in startups is really hard even for venture capitalists, because almost all startups operate under great uncertainty. Even a company that ticks all the boxes can fail.
In the startup world, there are no guarantees, and no framework is foolproof. But by deploying a framework such as OUTSIDE-IMPACTS, both investors and founders can at least improve their chances of success.