Making a single computer secure is hard enough. Making files and computers on the internet secure is really difficult. Still, there are many ways to keep people secure on the internet. Let’s look at a few of them.
Single sign-on
In the cloud, many systems talk to each other. Let’s suppose you’re attending a school and sign into their computer system. Your school may provide access to a library that is a part of another school. You can have access to this library but would need to get to it securely.
One way to access this other library is to sign in to it separately. You would have a sign-in for your school and another sign-in for the library. This is secure, but it has problems. First, it means you have to set up two accounts. You’ll have to remember the usernames and passwords for both. Second, the library may only want students at your (and other) schools to have access. In order to create a library account, you’ll have to verify you’re attending the school. This can take time and energy and can be costly for both the school and the library.
It would be easier if the library could just “trust” the users that sign in to the school’s system, wouldn’t it? This is possible with modern tools. With a tool called single sign-on, the school can send students to the library and automatically sign them in. The library knows that anyone who was sent to them by the school is verified (authenticated). Of course, the student has to sign in to the school first. But once that’s done, they can be “passed through” to the library.
Trusted sources
Another way to make access easier but just as secure is for one organization to trust another because the second has done all the work to validate the user. You may have signed in to a movie service or online shop using your social media username and password. In this case, the shop trusts that the social media company checked you out and so trusts signed-in users that the social media company sends them.
This is how it works. Suppose you go to an online shop (we’ll call it ‘Munson’s Pickles and Preserves Farm’) and need to create an account. One of the options for creating a valid account is to use your social media (say LinkedIn) sign-in. When you choose this option, you’re taken to LinkedIn to sign in. Once you successfully sign in, LinkedIn tells Munson’s Pickles and Preserves Farm that you’re a valid user and they should trust you. LinkedIn sends Munson’s Pickles and Preserves Farm information that they can use to trust you now and in the future.
This approach saves Munson’s Pickles and Preserves Farm from having to verify you since they can just trust LinkedIn. It also means you don’t have to create a new sign-in. You just use your LinkedIn username and password for both LinkedIn and Munson’s Pickles and Preserves Farm.
Most people who have used a computer know about passwords. People rely on passwords to prevent others from getting to their stuff. Computer systems use passwords to know that you are who you say you are. There are other ways we can access computers too. We can use our fingerprints or our face. All these ways help keep us and our stuff safe.
Knowing Who You Are
All these methods are ways computers use to verify a person’s identity. A valid identity tells a computer that the user is allowed to use it. Each of these ways verifies them because, ideally, only they know their password. Their fingerprint only belongs to them. Their face is, well, their face. In the language of computer science, this is called authentication.
Suppose you set up an account on a computer system (like a streaming media service, for example). When you sign in for the first time, you create a relationship with the system. You create a username and password, telling the computer you’re someone unique. If someone tries to sign in as you, they need to know your password along with your username. The combination is unique on that streaming service and should be known only to you.
A Clubhouse Example
Imagine that as a child, you created a club. You and a group of friends were in this club. You had a clubhouse. This was a place you’d meet and tell stories or eat snacks.
In this club, you made a “secret password” so only people with the password could get into the clubhouse. You’d spend a good deal of time trying to come up with the perfect (and usually funny) password. You’d whisper the secret password to each other and promised not to tell anyone. The next time one of you came to the clubhouse, someone at the entrance would ask for the password before they’d grant entry.
In this case, the password wasn’t used to make sure only certain people could get in. You and your friends all knew each other. Rather, you used the password to keep people out. If a parent, guardian, or stranger tried to get into your secret club, you could ask, “What’s the password?” If they didn’t know it, they couldn’t get in.
Passwords and other identification tools do both things. They tell the system who should be allowed in. But they also keep all others out.
What Can I Do?
Identity is only one part of security. Once you’ve gotten into a system, it may be important to prevent certain types of activity. For example, a family who shares a computer may give everyone access to a movie service. But they may want to restrict the kids from watching movies with a certain rating. Everyone can get in. Only the adults can watch all the movies. Computer scientists call this authorization.
Modern computer systems are designed so administrators can authorize people based on roles. Everyone with an “owner” role, for example, may have access to everything. People with a “member” role will have limited access. Members may have access to some files and can only do a limited number of things.
Going back to our clubhouse example, suppose the club had bylaws. The bylaws tell the members what the club is about and the rules everyone has to follow. The bylaws may say that only the president and vice president can vote on changes to the bylaws. Everyone else just gets to follow the rules. This may not be a great club, but this governmental system does show how authorization works.
Without authentication, anyone on the internet would be able to access any computer system. Without authorization, it wouldn’t be possible to restrict access to certain data, files, or services once a person has access to a system. By using both together, computer administrators have powerful tools to keep people and assets safe.
Now that we’ve gone over the fundamentals of what UX is, let’s consider design thinking and why it’s necessary on your journey as a founder.
Whether you’re a product manager, designer, or do any work around the topic of innovation, you’re most likely going to refer to design thinking.
User experience and design thinking are closely related. Design thinking is a creative problem-solving process that involves understanding user needs, exploring solutions, and testing ideas to create innovative products and services. UX is the practice of designing products and services that are easy to use and provide a positive experience for users. Design thinking is an important part of UX, because it helps to ensure that products and services are designed with the user in mind.
Key factors of design thinking
Design thinking is often used as a framework for UX design, as it helps designers to understand the user’s needs and develop solutions that meet those needs. The two approaches complement each other and are often used together in the design process to create products and services that are both functional and user-friendly. Before we break down each step of the design thinking process, let’s take a look at some of the key factors:
Understanding your userEmpathize: Understanding your user is an impetus to achieving empathy when looking to understand your user at their core.
Challenging assumptionsChallenge assumptions: The first step to challenging assumptions is to establish a hypothesis, which your research will look to prove or disprove your assumption(s).
Creating solutions that allow you to prototype and test the assumptions outA/B Testing: One of the most effective ways to test a hypothesis is to build and allow your user(s) to test assumptions out in order to refine the most optimal solution.
Now that you understand what design thinking is on a high level, let’s take a deep dive into each of its steps and how they can be applied to your product journey.
When it comes to the five steps of design thinking, it’s important to note that it’s not a linear process. This means that the steps don’t necessarily need to be done in a sequential order. In fact, one of the biggest reasons why design thinking is effective is because it’s a highly iterative process. Once you’ve managed to take an idea from inception to product, your work doesn’t stop there, because there will still be a need for continuous improvement as you gain more insights from users.
Five steps of design thinking
Empathize: To be able to deliver the best product or experiences, you first need to understand who your users are and what they need. What are the biggest challenges and pain points? To avoid operating under assumptions, it’s best to spend as much time as possible observing, engaging, and talking to potential users to gain better insight as to what an optimal solution looks like for them.
Define: Now that you’ve gathered all your findings and insights from empathizing with your users, you want to start to formulate a clear problem statement to guide you throughout the design process.
Ideate: After you’ve identified your target users and what they want, you can break down this phase into two steps: generating and deciding the ideas. “Bad” ideas are welcome.
Prototype: This is where the “magic” happens. The goal of this stage is to take the ideas from the ideation phase and start turning them into something tangible that you can put in front of actual users.
Test: Now that you’ve built the first iteration of your prototype, this phase is dedicated to testing your product to obtain real insights, from real users, in real time.
Let’s look at how this process looks like in a real-world scenario using our example, KrashAIO:
Key Factor
Design Thinking Phase(s)
Example
Understanding the user
Empathize
To gain perspective and insights on the problem space, a survey was sent out to multiple sneaker communities to understand their pain points as it relates to their unique online-purchasing experience.
Challenging assumptions
Define & Ideate
As a sneaker enthusiast, you understood that operating under your own assumptions would limit the possibilities of what an optimal solution looks like. To avoid this, once you collected the feedback from the surveys, you created two user personas that you referred to for the remainder of the initial product development process.
From there, you were able to brainstorm possible solutions based on the user’s needs, thus helping them draft their user stories, which would later become their first set of features.
Creating solutions
Prototype & Test
At this stage, the founders looked to put these ideas into action by creating a high-fidelity prototype based on the user stories. Their goal was to demonstrate its core functionality, information architecture (IA), and the user flow between screens.
At this stage, you created some basic screen designs to allow the user to complete their primary goals and help satisfy the basic requirement for each feature.
To get the best insights about the user flow, the founders decided it was best to test by allowing a select group of users to simulate going through and:
1. Creating a Task. 2. Creating a Profile. 3. Adding billing & shipping information.
From there, it was back to the drawing board to decide on building a Minimum Viable Product (MVP), where they took the next eight weeks to develop the desktop application so that they could begin testing with their community for feedback.
In conclusion, design thinking is a key framework to assist in creating a great user experience. It’s important to note that this is NOT a linear process and you should execute it with an iterative approach. Feedback is key to any product or company’s success, so it’s beyond imperative to be able to capture insights and apply changes as needed.
At its core, UX (User Experience) is how a product feels to your user while they interact with your product. This refers to the full experience, from the user’s first exposure to the product until their last. Whether it’s a positive or negative experience for your user, UX is about understanding your users’ various needs and how to meet them. A well-thought and strategized UX creates a friendly environment for users to fulfill their needs simply and without any hassle. UX design demonstrates a complete understanding of the user.
Here’s a look at some of the factors that influence User Experience:
You want to use a balance of the aforementioned factors to generate a quality User Experience. Let’s dig in:
Valuable: Above all, the product must provide value. When keeping value in mind, you’re confirming there’s a need and market for what you are building and that there’ll likely be success for the product in said market.
Useful: From the user perspective, the question in mind is “What’s the purpose of this product?” Although it’s subjective whether your product is useful to the user, you still want to deliver a product that ranks high in importance in comparison to your competitors.
Usable: Usability supports how efficient and effective a product is to the user. From a founder’s perspective, you want to create a solution with your users accomplishing their end goal in mind.
Findable: In the age of digital media and information being abundantly available, it’s beyond imperative that your product must be easy to find. The content must be readily available to find as well. In other words, if users can’t find the product, it’s going to be significantly more difficult to purchase and use the product.
Credible: Be it word of mouth, affiliation, or reviews, users want to be able to confirm that your product won’t just work for them, but work effectively. You gain your users’ trust when you can deliver a meaningful product built on honesty and the best intentions for the user.
Desirable: With a plethora of solutions and products on the market, it’s imperative that you set yourself apart from the rest. When it comes to design and UX, it’s important to put time and effort into the more ancillary parts of your product, such as the branding, the assets, and the overall aesthetic. To put it quite simply: the more desirable the product is, the more inclined a user will be to champion your product.
Accessible: In a perfect design world, every product would have an experience capable of being inclusive to people from all walks of life. You don’t want to neglect accessibility in the user experience. Accessibility in UX terms means that the user experience is extended to users with a range of abilities, including—but not limited to—those with disabilities.
UX considerations for KrashAIO
A beta version of the product was originally released to test how users could automate the e-commerce checkout experience in just a few clicks. One of the most important pieces of feedback we received from our beta users was that, unless you had the application open in front of you, there was no way for you to be alerted whether your checkout was successful or not.
When the final version of the product was released, we decided to implement a Notifications section in the Settings tab that allows you to select or toggle whether you’d like to receive desktop and sound alerts.
To create the best user experience and give your users a comfortable feel with your product, you need to include these seven factors of influence into their initial product journey. Remember, UX is about fulfilling the users’ needs with little to no room for hassle or difficulties. As a founder, you always want to maintain and keep the UX as fluid as possible.
The unfortunate reality is that most startups fail. The good news is that in many cases, these common causes of failure are avoidable. As long as founders are aware of the most common startup pitfalls, they can take steps to mitigate situations before they worsen.
Bear in mind that your startup failing doesn’t need to spell the end of your entrepreneurial career! Failing can be a great opportunity to learn what customers really want. Moreover, if the failure happens quickly and cheaply, you can pick yourself up and move onto another idea, applying the lessons you learned from your first attempt.
In this unit, you learn about the most common causes of startup failure, and some of the relatively simple actions you can take (or avoid taking) in the early days to maximize the chances of your startup being successful.
At the end of this unit, you can work through a checklist to score your startup against the indicators of startup failure. This list helps you identify any issues that you might need to address.
Building a product that nobody wants
By far the most common reason that startups fail is they build products that nobody wants. In reality, nearly every startup can find someone who will use their product. However, it’s essential that you find not only a common problem that people are having, but also that the problem is sufficiently intense or frequent for them. Such people will actively seek out a solution and pay for it.
Without proven demand from customers, it’s likely that you’ll build either entirely the wrong product or a product that’s not exactly what your target customer needs. This prevents you from creating a viable, scalable business.
In another module, we discuss methods for validating your idea with customers before you spend significant amounts of time or money building your product. This is a vital step in confirming that customers want your product and that it solves a real problem for them.
A derivative idea
Chances are you’ve encountered startups that are based on a derivative idea. These companies are modeled on successful existing products, but tweaked slightly to create something that’s more useful to a narrower set of users or a narrower geography, or that has a slightly different feature set. In some cases, the startup is essentially an alternatively branded version of the original product with no substantive changes.
For example, derivative startups might include, say, a social network just for pet owners, a rideshare company that operates in one specific city, or a voice-chat product that’s invite-only instead of open to anyone.
Often founders with derivative ideas believe that the market is big enough to accommodate multiple, similar competitors. It’s true that startups based on derivative ideas can be successful, especially if the original idea has overlooked a certain segment of users by trying to cater to a very broad audience.
However, in most cases, startups based on derivative ideas have a tough time achieving real scale. It’s usually not difficult to acquire some users and generate some revenue, but it’s much more difficult to take significant market share from existing companies that already have product-market fit and a recognized brand.
A good example of derivative brands is the recent surge in “mattress-in-a-box” e-commerce companies. These companies produce mattresses, sell them via online stores, and ship them in space-saving, rolled-up packaging to customers. They don’t have a physical retail presence. This is a fundamentally sound business model, because it enables the company to have lower overheads and lower prices than traditional retailers. This business model also provides a more convenient shopping experience for customers.
The mattress market is large enough to accommodate multiple competitors, and it’s true that a number of the mattress startups that followed Casper have been successful due to new product innovations.
However, with derivative ideas, there’s a problem with diminishing returns. Being one of the first few entrants in a new business category can be great, but being the tenth or twentieth of these companies is pretty tough.
The previous unit of this module touched on the importance of technology tailwinds. It turns out that mattress-in-a-box startups all leveraged one crucial technology tailwind: the recent development of “roll-pack” machines. These machines enable mattresses to be produced and packed down into a small, easily transportable package. Without this new capability, none of these mattress-in-a-box startups would’ve been viable.
Competing with free
Let’s say you’re going to create a product that allows people to do a certain task, and they’re currently able to do that task by using something that’s free and readily available. Examples of this particular scenario might include a spreadsheet or a Facebook group.
In these instances, you’ll need to give potential users a compelling reason to use your product, because:
You’re asking them to stop using something that they’re familiar with and that currently works for them, even if it’s imperfect.
You’re asking them to try something new and learn how to use it.
You’re asking them to pay money for something that was previously free.
If you’re competing with free, a good rule of thumb is that your product needs to be 10 times better than the free alternative. It’s only by providing a massively improved experience that people will change their behavior.
Tip
Ask yourself: How imperfect is the free solution that my target users are currently using? Can I greatly improve the way in which they complete the task? How can I make my product as simple as possible to learn and use? Are users more likely to use my product if I offer a free trial?
Attempting to scale before achieving problem-solution fit
It can be extremely tempting for startup founders to double down on a product as soon as it acquires its first few customers, or generates the first few dollars of revenue.
However, attempting to scale a company based on a relatively weak signal from a small number of users is a risky strategy. These users might be exceptional, and might not represent the larger cohort of future users. Other, closely related products might serve a much larger adjacent market, but you just haven’t identified that adjacent opportunity yet.
Successful startups share a number of important attributes. In this unit, you learn about some of the most common shared attributes of successful startups, and you can score your startup against them.
By understanding what makes startups succeed, you’re able to bake some of these attributes into your startup from the very beginning.
Non-obvious idea
Every startup needs to be based on a good idea. Unfortunately for many founders, the idea they decide to work on is self-evidently good. This means that many other people are likely to have had the same idea, and the company will therefore most likely be competing with other startups, or even large enterprises, doing something similar.
Some of the best startup ideas sound wild at first but are actually a good idea. This makes them a great startup idea, because not many people are working on the same thing.
Consider the following Venn diagram:
The blue set on the left represents all ideas that sound absurd. When you first describe these ideas to people, their most common reaction is: “That wouldn’t work.”
The green set on the right represents all ideas that are in fact a good idea (that is, they could be the basis for a product that customers want and would pay for).
Not many people start off with ideas that sound absurd and are in fact absurd (the blue set on the left, excluding the intersect). That’s good news, because the world doesn’t need any more perpetual-motion-machine inventors.
However, many people tend to come up with ideas that are perfectly good, but are very obvious (the green set on the right, excluding the intersect). There’s a good chance that many startups are working on a similar idea.
Keep in mind that it’s fine to have some competitors, because this validates that the opportunity exists and that there are customers who are looking for this solution. However, having many direct competitors is a tough starting point for any startup, particularly if those competitors are further along in their product development and have significant capital to maintain their market lead.
Some of the best startup ideas exist in the intersection between these two sets. They’re both a good idea (the green set) and non-obvious (the blue set). These startup ideas are counterintuitive to most people. Generally, these ideas are only visible to those with deep insights into the problem space, often acquired over long periods of time.
If most people think your startup idea won’t work, but you have some unique insight that convinces you that they’re wrong and you’re right, then you could be onto something.
Case study: Airbnb
When Airbnb started, many smart people looked at the idea and said: “There’s no way people will give their house keys to a stranger and let them stay in their house just to make a few extra bucks. It won’t work, at least not at scale.”
Of course, today we know that Airbnb is a wildly successful tech company. The founders’ unique insights gave them the ability to see past this objection and pursue a business model that most people thought wouldn’t be viable.
Task: Research your competitors
Imagine you’re trying to raise money from a venture capital fund and you send them your pitch deck. One of the first things they’ll do is consider the competitive landscape and make an assessment as to whether your startup is doing anything new, or at least different than existing competitors.
Now, put yourself in the shoes of the analyst at that fund. Spend half an hour doing some online research on your company’s problem space and see how many competitors you can find. Don’t just look for direct competitors that are doing the same thing, but also indirect competitors that might provide an alternative solution to the same problem.
Does your startup stand out as doing something new and innovative, or does it appear to be one of a large number of undifferentiated competitors?
The right team
It’s fine to be a sole founder at the outset, but before long most founders realize that having a team is critical to the success of their company.
Furthermore, startups also need a range of skill sets and perspectives, and just about every founder benefits from the moral support of being part of a team. Having people you trust as thought-leadership partners within the team can help you to weather the inevitable emotional ups and downs of establishing a startup. The team helps you build the resiliency necessary to get through the most challenging periods. Moreover, these individuals can provide different approaches to problem solving that will ultimately contribute to faster progress.
Task: Complete a startup skills checklist
Complete the following startup skills checklist to see how your team stacks up. There’s no absolutely right mix of skills, but if you find there’s an obvious gap, now is a good time to start working on filling it.
☐ More than one founder ☐ Diverse backgrounds and perspectives ☐ Domain expertise relevant to the target market ☐ Tech skills suited to building the product ☐ Design skills ☐ Sales skills ☐ Communication skills ☐ Leadership skills
Intense customer pain
You might have heard of “painkiller” companies versus “vitamin” companies. Painkillers are the ones that are solving a significant pain for customers, whereas vitamin companies are making products that might be useful but are more of a “nice to have” than a “need to have.”
The benefit of being a painkiller company is that your target customers are probably looking for a solution to whatever problem is causing them the pain. Maybe they’ve tried other products, or even invested time and money trying to create their own solution.
A useful way to think of customer pain is with reference to intensity versus frequency. Problems that are intense are more likely to cause customers to actively seek new possible solutions than problems that are mild. Similarly, problems that occur frequently are better motivators than problems that only occur very occasionally.
If you’re looking at a number of customer pain points that you could address, try plotting them on a chart with intensity and frequency on the axes. The problems in the top right quadrant (high intensity, high frequency) are likely to be the best ones to go after.
Scalable business model
Successful startups tend to be highly scalable, meaning that they can grow rapidly. Scalable startups can become increasingly efficient in terms of resource requirements as they deliver their product to an expanding customer base.
If your business model relies on having to perform repetitive, non-scalable tasks (even doing in-person sales calls), you might face major barriers to scalability and growth. That’s because these constraints might place an upper limit on the number of customers you can serve.
The following simple graph illustrates a non-scalable company that’s delivering services to customers. Let’s say it’s a graphic-design business. As the company gets more customers, it does more graphic design work and generates more revenue. At the same time, however, it needs to employ more graphic designers, so its costs increase proportionally. At some point, it stops growing and its revenues and costs plateau. As long as revenues exceed costs the business is making a profit, which is of course a good thing. However, this isn’t what scalability looks like.
Now let’s look at a scalable business model.
In a scalable company, at some point revenues become decoupled from costs. For many companies, this is because they’re taking advantage of the inherent scalability of the internet.
If your product is software or something that can be achieved through software, after your product is built, the incremental cost of digitally delivering your product to each additional customer is very close to zero.
After you’ve built the product and invested in developing and launching it, a scalable business model enables your company to grow rapidly.
Large opportunity
The success of a startup is a function of volume and value; volume being the number of customers it can serve, and value represented by what those customers are willing to pay for the startup’s product or service. Volume and value in turn dictate the economic rent the company is able to capture, and the overarching size of the market the startup could potentially address.
Startup founders should aim to serve as large a market as possible and ensure that their product creates meaningful value for customers.
As noted by Marc Andreessen, founder of Netscape and cofounder of the venture capital firm Andreessen Horowitz, “software is eating the world.” Every industry is being disrupted by software companies, resulting in massive shifts of economic value from old, legacy companies to new, digitally enabled ones. There are countless opportunities to build companies capable of disrupting multibillion-dollar markets, so why create a company that’s serving a narrow niche or focused just on a small market?
Tip
Ask yourself: Am I focused on a large and growing market? Are there enough people who will rely on my product every day to make this an opportunity worth pursuing? Is this a market that’s dominated by large, inefficient incumbents who could be disrupted by my solution?
Remember that you could be devoting the next 10 years of your life to this company, so the prize had better be worth the effort!
Timing
There’s an optimal time for every startup idea. Make sure that you’re not launching your startup too far ahead of the opportunity, or too far behind.
An example of launching too far ahead of the opportunity would be a marketplace for sharing quantum computing capability. Quantum computing is going to be a huge opportunity at some point, but it might not be wise to set up a marketplace for sharing that capability today; you’d be some years ahead of the curve.
Conversely, you’d be a brave person to start an online bookstore company today. The optimal time for starting that business has passed.
Task: Identify timing factors
Make a note of any factors you can think of that affect the timing of your company. Is now a good time for this idea? Why?
Tailwinds
On a related note, the best ideas often benefit from tailwinds that help push them along. These are shifts in technology, consumer behavior, or regulations that make it easier to get your startup started (or that make it possible, if it would’ve previously been impossible).
Uber benefited from tailwinds when it launched in 2009. The founders had identified a growing acceptance of the sharing economy by consumers, as well as the emergence of ubiquitous GPS and high-quality maps on smartphones (noting that the first iPhone was released in 2007).
Had someone tried to launch a ridesharing app like Uber five years earlier, it wouldn’t have made sense. Similarly, if someone were to start another rideshare company today, it would face stiff competition from existing ridesharing apps that have already established traction, market share, and a strong brand.
Task: Identify tailwinds
Make a note of all of the tailwinds you can think of that might benefit your company. What can you do now to capitalize on them?
Inherently shareable
The cheapest way to acquire a new customer is by having an existing customer refer someone else to your product.
A large proportion of successful startups deliberately built features that make it easy for users to share their product, and this shareability contributed to their massive growth.
Hotmail is a great example. The company started in 1996, and at that time was just about the first browser-based email service. Browser-based email is ubiquitous and free today, but in 1996, in the early days of the internet, nearly everyone’s email address was tied to their ISP. That was inconvenient because if you changed your ISP, you had to change your email address.
Hotmail decided to make their product shareable by putting a footer at the bottom of every email that read “Sent from Hotmail. Get your free email here.” The result of this shareability was that many people got a Hotmail address.
Over the course of a year and a half after launching, Hotmail grew from zero users to 9 million users, and was subsequently acquired in late 1997 by Microsoft for a reported $450 million. (For more information, check out Microsoft Acquires Hotmail, List of mergers and acquisitions by Microsoft, and How Hotmail changed Microsoft (and email) forever.) Today, 9 million users doesn’t seem like much, because there are billions of people on the internet; but in 1997, this represented around one out of every eight internet users.
Task: Find ways to share your product
Make a note of the five software products that you use most often. See if you can find a way that each of them has been deliberately designed to be shareable. Does the company give existing users an incentive to share the product with new users? Do you think this has contributed to the company’s growth?
Think about what features can you build into your product from the beginning that will make it easy to share. How can you provide users an incentive to share it?
Recurring revenues
Unlike one-off sales, recurring revenues occur on a regular, ongoing basis. For example, software-as-a-service businesses that bill customers through a subscription agreement generate recurring revenues. With this type of business model, as long as the customer continues using your product and paying for it, you’ll continue making money.
Recurring revenues are highly attractive because:
They can lead to a high customer lifetime value (LTV).
The cost to retain an existing customer is almost always lower than the cost to acquire a new customer.
Revenues are predictable as long as you have a high level of customer retention.
Predictable revenues enable more confidence in investing in product development, often leading to better products over time.
Companies that generate recurring revenues can scale much more rapidly.
Investors are usually more interested in businesses that generate recurring revenues than those that make one-off sales, because each new customer is building cumulatively on an existing revenue base.
Customers often prefer to spread the cost of your product over a monthly billing cycle rather than having to pay for it up front.
Let’s assume that you’re here because you’re working on an early-stage startup or a startup idea. You’d like to make sure you have a good grasp of essential startup concepts before you go much further.
How will you know if founding a startup is right for you? For many startup founders (and aspiring founders), there are a few critical considerations that can help to answer this important question.
Are you passionate about solving a specific problem?
To be a successful entrepreneur, you need to be passionate about solving a problem. Many successful entrepreneurs report that they would have pursued their idea regardless of whether there was a business opportunity; they were that passionate about solving that particular problem.
The road from startup idea to successful business is often a long one, with the typical time from launch to exit being anywhere from 4 to 10 years.
Bear in mind that few startup founders set out with anything like this commitment up front. It’s entirely rational to start a company with a modest time horizon and become more committed as the opportunity solidifies and the company grows.
Nevertheless, it’s much easier for you to devote meaningful time to solving a problem if you’re passionate about it. This is especially the case in the early days, when there’s likely to be lots of hard work and before you reach any significant commercial milestones.
Tip
Ask yourself: Am I passionate about solving this problem, and can I imagine devoting years of my life to working on it?
Do you have deep domain expertise?
The odds of a startup succeeding are always higher if the founders have unique insights into the problem space—or domain expertise—in which their startup is going to operate. These insights are typically acquired over a long period of time (either through work or a personal interest), accompanied by a thirst for understanding problems and exploring potential solutions.
In fact, in the early days of many startups, these unique insights are the only competitive advantage the company has. So, it’s important to make sure you’re able to identify and articulate the insights on which you’re going to base your startup.
There are four main ways in which startup founders can take advantage of their domain expertise to create value:
By identifying an important problem that many others don’t realize exists. Many great startup ideas came from time spent “marinating” in the problem space, exploring interesting problems with potential customers and developing unique insights over a long period of time. Finding great problems to work on often means skipping over the problems on which everyone else is working and identifying others that are hidden or that seem unsolvable, but that still represent a great opportunity.
By coming up with a compelling solution that’s unlikely to occur to others, and might even seem unlikely to succeed. Historically, many of the best startup ideas seemed wild at the outset, and it was only with hindsight that their value became evident.
By making connections with customers that would be difficult for a newcomer to make. Founders can tap into their existing network, or use their profile as a thought leader.
By developing novel, cutting-edge technology that can become the basis for the company’s competitive advantage. Especially with deep-tech startups that are based on advanced technology or scientific research.
Tip
Ask yourself:
Does my startup idea take advantage of the time and energy I’ve already invested in my career or my other interests?
What insights do I have (that most of my peers don’t) that will open up an opportunity that might have been invisible to others?
How much financial freedom do you have?
Almost all startups require an up-front investment in product and market development before meaningful revenues start to flow.
Technically capable founders might have a slight advantage over non-technical founders. They can spend their time building the product, rather than having to spend cash to pay an external developer to build it for them.
Nevertheless, it’s vital that all startup founders understand the likely cost of building and launching their product. This awareness helps them budget for this expenditure and ensure that they can get their product in the hands of customers before they run out of money.
As a startup founder, you need to work on three tasks to determine your startup’s financial runway:
Understand the cost of building and launching your product. This estimate should include all outlays, including legal, marketing, and staffing costs.
Predict the likely revenues you’ll generate when the product is in the hands of customers. Consider how long it will take to reach that juncture.
This prediction is the trickiest part, and many would argue that forecasting future revenues for a pre-launch startup is at best a rough guess.
Almost all startup pitch decks are heavily influenced by optimism bias. They have a revenue chart that goes steeply up and to the right. A good rule of thumb is to double the length of time you think it will take to get to revenue, and halve the amount of revenue you think you’ll generate.
Determine how much capital you have and are willing to invest in the company before it receives funding from revenues or external investment. If you have cofounders, this is a great topic to discuss as a team.
Answering these questions helps you develop a cashflow forecast that allows you to make informed decisions about where to invest time and money early on.
What is your risk tolerance?
A startup is one of the most uncertain business environments in which you can place yourself. To be successful as a startup founder, it’s critical that you’re not just comfortable with uncertainty, but that you thrive in this dynamic environment.
An important part of this process is considering your own risk tolerance in the context of your personal financial commitments.
Everyone has their own unique risk profile, but as a generalization, risk tolerance for most people is highest when they’re young. Younger individuals tend to have relatively few financial obligations and don’t yet have an established career. If founding a startup doesn’t work out (or takes longer than planned to get off the ground), it doesn’t seem like that big of a deal, at least financially.
Risk tolerance generally decreases over time. As people take on financial commitments like buying a house and have responsibilities such as supporting a family, they tend to be less willing to take large financial risks.
Additionally, opportunity cost generally increases over time. It can be more difficult to leave a successful career in which you’ve invested over many years than to start something when your career is still in its infancy.
As a founder, you should think about your own risk tolerance at the beginning of the startup journey. If you have cofounders, this is an excellent time to have a frank and open conversation about each individual’s risk profile and financial situation. It’s a good idea to find out whether you’re collectively aligned on these fronts.
Tip
Ask yourself: How much cash am I willing to put into this company? How much income am I willing to forego as I work on this company instead of doing other paid work? What’s the minimum income that I need to generate, and can I do that while working on this startup? What are my financial objectives, and will they be met by building this startup?
Are the cofounders aligned?
Misaligned expectations among cofounders can lead to a loss of team cohesion. This is one of the most common causes of startup failure, particularly if it occurs early in the startup’s life.
Cofounder misalignment can take many forms, including:
Differences in the amount of time, money, and/or energy each founder is willing to put into the company, particularly before it generates significant revenues or raises external funding.
Differences in what each founder wants to get out of building the startup. These differing desires can include financial reward, freedom, self-actualization, or fame and recognition.
Differences in how each founder views success for the company. They might have differing goals about financial success, impact on the world, solving the problem on which the startup is focused, or some other outcome.
The good news is that by identifying misalignment early on, it’s often possible to address any issues before they become a destructive force.
One way to do this is for cofounders to each reflect on their individual goals for the company and themselves, to write these down, and then to come together as a team and discuss their responses.
Even if you’re a sole founder, it’s still useful to capture these thoughts and discuss them with friends, family, or your partner. You can “pressure test” your own goals and the viability of your expectations.
Worksheet
Download and complete the Founder Alignment Exercise worksheet. Use it to start discussions with your cofounders (or if you’re a sole founder, with your friends or family).
When should you go full-time?
At some point, founders need to make the decision to step back from other work in order to focus exclusively on building their startup. However, it’s a common myth that startup founders should commit full-time to their startup from the beginning.
For most people, this isn’t a rational path. If you have finite financial resources and some immovable financial commitments, it’s generally wiser to commit to your startup incrementally. Start with a small time commitment, during which you test your idea and establish whether it’s worth proceeding any further.
It’s helpful to think about the early stages of your startup as an opportunity to explore and experiment. You don’t need to lock in a business model or decide on exactly what product to build right away. Instead, approach these things iteratively over a period of time so that you can have some certainty about what product to build and who’s going to pay for it.
Many people can do this part-time around their existing job or other commitments.
By identifying critical milestones or inflection points that allow you to build increasing conviction, you can identify stages in the development of your company. These stages allow you to commit additional time and money as you gain greater certainty about the prospects of your company.
Founders should consciously decide to invest their time and money into their startup in the same way that an investor would decide to invest in your company. Base your investment on a rational and hard-nosed assessment of the company’s prospects, including the extent to which the founders have been able to identify, address, and retire the core risks that could cause the startup to fail.
For example, make an investment case to yourself that begins: “It’s rational for me to invest this amount of my time and/or money at this point, because…” The things that should convince you that it’s sensible to invest might include validating core assumptions, receiving positive feedback from potential customers, and generating early revenues.
Scenario: A milestone chart for commitments
Emily is working on an idea for a financial tech startup that she hopes will make it easier for people to consolidate the bank feeds they receive from multiple banks. She comes from a consumer banking background, and she’s pretty sure the idea has value.
However, she’s decided that she wants to test some of her assumptions with potential customers. Moreover, she wants to do this before making any moves to leave her job or investing significant amounts of time and money in building a product.
Emily has decided that she’ll stagger her commitment of time and money to the company by using milestones that reflect the de-risking of the opportunity. To help her think this through, Emily created a milestone chart and penciled in some commitments that she’d be willing to make as she hits each milestone.
When I hit this milestone
I’ll be willing to invest this much time in my startup
I’ll be willing to invest this much of my own cash
This is rational because
Complete 50 customer interviews, and at least 50 percent identify with the problem and would be interested in a solution.
One person-month (evenings and weekends) over the next three months to build a minimum viable product (MVP).
$500 to run some social ad campaigns to test demand.
I won’t need to reduce my income and I have enough savings to pay for the ads.
Launch MVP, get at least 100 people using it, and collect positive feedback.
One day per week (reduce job to four days), plus evenings and weekends, to focus on building version 1 of the product and connecting with at least three banks.
$5,000 to hire a front-end developer to help build the product.
I’ve discussed this matter with my manager, and she’s supportive of me taking time off to explore this without jeopardizing my employment.
I have enough savings to cover the reduced income and am willing to cut back on some discretionary expenditure.
Launch v 1.0 and get first 50 paying customers.
Leave my job to go full-time, but with up to two days a week available to do contract or project work if I need the income.
$10,000 to keep front-end developer working on the product, and to do some paid customer acquisition.
Having 50 paying customers demonstrates demand for the product and represents $5,000 in revenue.
200 paying customers and at least 90 percent retention of the first 50 customers after six months.
Full-time
$20,000 in savings, will need to raise seed round soon!
200 customers equate to $20,000 in revenues.
High retention rate supports assumption of high lifetime value of customers.
Should be enough to raise a seed round.
Worksheet
Download and complete the milestone worksheet. Use it as a tool to capture your thoughts about what milestones you’ll need to hit before you’re prepared to invest time and cash in your company.
Remember that this is a living document, and you’ll need to adjust the milestones and your commitments as you progress.
Raising money for your startup is one of the hardest things you’ll do as a founder. It can be an intense and time-consuming process. It often involves many rejections before a round is successfully closed.
In this unit, we cover some practical tips to help you approach the right investors and streamline the process of raising a funding round.
Create an investor wish list
Most funding rounds involve more than one investor. Two to five investors is typical. It’s common for startup founders to approach dozens of investors before they get the small number of commitments needed to close a funding round.
How do you decide which investors to approach, and in what order?
The first step before you contact any investors is to do research and determine which investors might be interested in your company. Consider the sector focus, stage of investment, and geography. Most investors prefer to invest in companies located close enough that they can meet in person (although this preference has changed markedly over the last couple of years).
After you have a list of potential investors, rank them in order of preference. At the top of the list, are the investors that you most want to have as shareholders in your company. This ranking might be because of their sector experience, networks, or strong brand. Maybe you spoke with the founders they backed previously who told you that they’re great to work with.
At the bottom of the list, are the investors that you would be willing to have as shareholders. They might be less desirable because they have shallower expertise in your sector. Or, they’re general partners who don’t have experience as founders, or the feedback about them from other founders is less positive.
Don’t contact investors from whom you wouldn’t accept an investment; this wastes your time and theirs.
There are two schools of thought on which investors to approach first:
If you’re confident of your investment proposal and your pitch is polished, start at the top of your list. Pitch the investors you most want to invest in your startup. If they agree to invest, your funding round closes more quickly and you avoid wasting time with less valuable investors.
If it’s your first time raising a funding round, your pitch is a little shaky, or your company only just meets the investability threshold for your target investors. It might be a good idea to start at the bottom of your list.By pitching less desirable investors, you gain experience in pitching your startup. You also receive feedback and questions from these investors that you can integrate into subsequent pitches. By the time you make it to the top of your list, your pitch will be more solid and you can anticipate many of the questions you’ll receive.The disadvantage of the second approach is that it takes longer. You’ll have more meetings, and you might even receive investment offers from your nonpreferred investors. Many founders find it difficult to say no to an investment offer, because they run the risk of saying no and then not receiving offers from any of their preferred investors.
Make contact with investors
Almost all investors allow startups to send unsolicited pitches, either by cold email or through a form on their website. Well-known investors often receive many hundreds of unsolicited approaches that are of highly variable quality. As a result, your pitch might receive little time and attention.
In contrast, most early-stage investments come via referral from someone whose judgment the investor trusts. These pitches are often taken more seriously and receive a more thorough review.
After you decide which investors to contact, get a warm introduction via a mutual connection if you have one, or through a founder of one of their existing portfolio companies.
Building relationships with investors takes time. Most investors are receptive to having informal discussions with founders well before you begin the process of raising your funding round.
Investors are often happy to share their experiences with early-stage founders as part of their outreach and deal-sourcing activities. By getting to know you and your company, they’re able to offer you some light-touch input and connections to other founders or investors, potentially over a period of a few months.
At the same time, they get to see you in action. They get a sense of the speed and urgency with which you execute, and see whether you follow through on the advice and connections they offer. They can also gauge whether they might be happy in a long-term business relationship with you.
By building relationships with investors in this way, you increase the chances of them committing when you’re ready to open your funding round.
Approach investors in parallel rather than in series
One of the most common mistakes made by first-time founders is to approach too few investors at the outset.
After you contact an investor, it might take several months before you know whether they’re going to invest. If you only contact a handful of investors, you run the risk that all of them will pass on the round. Then you have to restart the entire process with another set of investors, which increases the time it takes to close your funding round.
Approaching investors in series also means you have little opportunity for competitive tension, so there’s less incentive for each investor to offer attractive terms. It can even lead to unfavorable terms if investors know that without their money, your company could run out of cash.
Finally, startups that are on the fundraising trail for an extended period start to look questionable. Investors will ask why your required funding is still secured after many months.
In contrast, if you make initial contact with 10 to 20 investors in parallel, you increase the chances of closing your funding round quickly. The up-front workload is higher, but this approach allows you to treat fundraising like a sales funnel and prioritize your efforts on those investors who appear most likely to proceed. Even if most investors pass on your funding round, you have enough candidate investors in the pipeline that you don’t need to restart the entire process.
You might also be able to achieve some competitive tension as investors realize they need to move quickly and offer attractive terms to not miss out.
Find a lead investor
Most funding rounds involve multiple investors, but in most cases one investor does most of the pre-investment work and is often the first to commit funding. This investor is referred to as the lead investor.
Finding a lead investor is important, because their commitment signals to other investors that someone they trust has evaluated your startup as a worthy investment. This phenomenon is noticeable when the lead investor is a top-tier venture capital fund or well-known angel investor. On many occasions, previously undecided investors commit within days of learning that a lead investor is committed to a funding round.
As a startup founder, one of your objectives is to find true believers who will make an early decision to back your company and help you secure the other investors you need to close your funding round.
Conversely, it’s rarely a good idea to spend time trying to convert potential investors who are on the fence, or who don’t show a sense of urgency in making an investment in your company.
Understand term sheets
A term sheet is a short legal agreement between your company and an investor that sets out the key terms of a proposed investment. Term sheets are normally not legally binding, except for clauses relating to:
Confidentiality: You can’t disclose the term sheet to other parties.
Non-solicitation: You commit to proceeding with the investment and can’t shop the term sheet around to other investors in an attempt to secure better terms.
After investors sign a term sheet, they commence due diligence, as discussed in the following section. If no major issues are identified, the transaction is documented in a more substantive set of legal agreements. Funds will only be transferred to your company’s bank account after these agreements are signed.
Term sheets are an important part of the fundraising process. They allow investors to make an in-principle commitment to invest, but without the overhead of negotiating detailed legal agreements. They also allow startups to have some degree of confidence about which investors are committed and on what terms.
The content of term sheets is beyond the scope of this unit. As a startup founder, you should be familiar with the key terminology and concepts contained in term sheets. You should also put some thought into preparing a term sheet of your own.
In this unit, we explain three of the most common types of startup investors: friends and family, angel investors, and venture capital (VC) funds.
Friends and family
It’s common for startup founders to raise their first funding round from friends and family members.
The motivations of these investors vary. Typically, they want to support the entrepreneur. For example, the investor might be your uncle who wants to help you get started. They also might want to try to generate a return from their investment by getting in early.
It’s worth noting that friends and family are generally the only investors who will fund you when all you have is an idea for a company.
Friends and family can be a good source of early capital if they’re happy to be passive investors and don’t expect to be involved in running your business.
For most founders, the biggest challenge with friends and family rounds is that you have a friend or a family member who’s now a shareholder in your company. They’re financially exposed to the success or failure of your business.
This arrangement can have a profound effect on your relationship with that person. It’s wise to think about how to manage this relationship over the long term.
Tips for raising money from friends and family:
Before any investment is made, discuss expectations. Ensure that you agree on the likelihood of success and failure, time frames, and how the company should be run.
Agree on a reasonable valuation. For example, your uncle might not have a grasp on startup valuations. While it might be tempting to set a high valuation, it might cause trouble when you raise your next round from more sophisticated investors.
Have a legal agreement that sets out the terms of the investment. Is it an equity investment, a loan, or a gift? How will the investor be compensated? What happens if the company fails? What input, if any, will they have?
Make sure the person can afford to lose their investment.
Angel investors
An angel investor is a wealthy individual who invests their own money, like Melanie in the previous unit’s example. In many cases, they’re successful entrepreneurs themselves.
Good angel investors bring capital along with expertise and networks that can help you grow your company. Angel investors often work in groups. An angel round can have a few or sometimes 20 or more individual investors participating.
Angel groups often invest in a wide range of sectors, with their investment interests influenced by their members’ individual expertise.
Generally, angel investors will consider investing in a startup only after it launches at least a minimal viable product and generates traction in the form of product usage and, ideally, revenue.
Tips for raising money from angel investors:
Research the investor and ensure that their investment profile is a match for your company. Consider the stage, size, and sector of their investments.
Find opportunities for warm introductions via other founders who raised money from the angel investor or angel group.
Speak to founders of portfolio companies to find out whether their experience with the investor was positive.
Be prepared to send your pitch deck in advance of any meeting. Most angel groups ask you to upload a pitch deck or executive summary via their website before they’ll meet with you.
Venture capital
VC funds are professional investment firms managed by general partners who were often successful entrepreneurs themselves. VC funds generally invest money provided by institutional investors like limited partners such as pension funds. These investors allocate funding to VC firms as part of their diverse portfolio of investments.
Some VC funds invest at seed stage, but it’s more common for them to invest at Series A and beyond. They normally invest larger amounts than is typical for angel investors.
Most VC firms have a 10-year lifespan. They go through distinct phases:
Sourcing investments and investing, usually in the first five years.
Managing investments and supporting portfolio companies.
Making follow-on investments.
Exiting investments.
It’s important to know where a VC fund is in its life cycle. There’s little point in pitching a fund that’s in its ninth year of a 10-year life.
VC funds generally have a preferred investment stage, like seed, Series A, and Series B. They also often focus on one or more specific sectors, such as blockchain, AI, and health tech.
Generally, VC funds will consider investing in a startup only after it launches a product, generates early traction, and can show strong evidence of product-market fit. At that point, it’s common for the company’s growth to be limited by capital rather than by customer demand. The funding allows the company to rapidly accelerate customer acquisition and growth.
Tips for raising money from VC funds:
Apply the preceding tips for angel groups, they also apply to VC funds.
Be prepared for multiple meetings and a time frame of several months from initial contact to investment close.
Have a comprehensive set of due-diligence resources assembled so that the fund can complete its due diligence without adding extra delays.
Not all money is equally valuable
Good investors can add significant value to your company by sharing their expertise and networks. They can also provide guidance to the founders as they work on growing the business. Recognized investors, such as top-tier VC funds, also add credibility by association. Their involvement might make it easier for you to raise subsequent funding rounds.
There are investors who add limited value, such as friends and family, as we discussed previously. There are also investors who add negative value.
A good rule of thumb is that smart, involved money is better than dumb, passive money, which in turn is better than dumb, involved money.
The benefits of smart money are clear. Smart money comes from someone who has relevant expertise. Being involved means they’re willing to commit meaningful time to helping you grow your company.
Dumb money comes from people who don’t know much about your business or about how startups work. Being passive means they’re prepared to take a back seat, and they have no ambitions to contribute to running your company. Dumb, passive money is fine if you have access to other sources of experienced guidance and the investment is on general terms.
Dumb, involved money is problematic. It comes from people who don’t have much value to contribute, but who insist on having an active role in your company. Sometimes dumb, involved money comes from inexperienced angel investors who created wealth in other sectors, such as retail or property investing, and want to try their hand at angel investing.
It’s wise to avoid these investors. Experience shows that the challenge of managing their involvement frequently outweighs the benefit of the capital they provide.
At its most basic, raising money from investors means to sell a stake in your company in return for cash. The investor obtains an economic interest in your company. They also gain some degree of control by virtue of the rights attached to their stake.
Bootstrapping vs. funding externally
The difference between a bootstrapped company and an externally funded one can be seen in the following two charts, which show net cash flow over time.
In the first chart, the company is growing organically. The founders self-fund it until it can generate customer revenue. At that point, revenue is the main source of funding for continued growth. This type of funding is commonly referred to as bootstrapping.
A self-funded, or bootstrapped, company can tolerate negative cash flow only to the extent that the founders can fund the company personally. After the company begins to generate revenue and achieves positive cash flow, its rate of growth is limited by the rate at which revenue is generated.
The following chart shows cash flow in an externally funded startup. Such a company can tolerate a greater level of negative cash flow, which allows it to invest more in product development and customer acquisition. After the product is launched, it can achieve a steeper rate of growth.
Higher growth is one of the primary reasons that startup founders seek external capital to fund the growth of their companies.
Why raise money?
There are other reasons that startups raise money from investors beyond maximizing growth.
Having the backing of a good investor brings access to capital and expertise, both of which can greatly enhance your ability to grow your startup into a large and successful business.
In many cases, startups require a large up-front investment to build the product and get it in the hands of users before generating meaningful revenues. In these instances, it might not be feasible for the founders to self-fund the company, so raising external capital is the only option. This is especially true for deep-tech companies or those organizations that develop complex physical products.
If you’re competing in a large and global market, you probably have competitors. If they have significant amounts of capital, you might not be able to compete meaningfully without access to similar amounts of capital. Bootstrapping your company with limited funding might make it impossible to compete in your market.
Why not raise money?
There are some good reasons why raising money from investors might not be a good fit for you.
First, you might not need external capital. If you can self-fund your company or generate customer revenue early enough, bootstrapping your startup can be the best path to take.
You also might not want to start a high-growth company and swing for the fences. Taking external capital from an investor brings with it a set of expectations. As we discuss later, most investors are interested only in backing companies that can experience massive growth and generate a large financial return. It makes sense to want to start a company that grows at a more modest pace. Such companies often provide founders with an ongoing source of income and allow them to be in control of their own work-life balance.
When you raise external capital, you’re giving up some control over your company because you’re no longer the sole owner. The company goes from being my company to our company.
One way to think through this decision is to weigh the advantages and disadvantages. On the downside, you have to give up some control. On the upside, you have the capital to increase the odds that the company grows and succeeds.
A worksheet like the Founder Alignment Exercise is a useful input to help you decide which kind of company you and your cofounders want to build.
Control and dilution
When you raise money from an investor, they want some input on how you run the company. They need this information to protect their investment and ensure that they’re able to contribute positively to the company’s growth.
Their input might take the form of a seat on your board of directors or a board observer position, or it might take place informally through regular meetings with the founders. It can also involve giving the investor voting and veto rights on key strategic decisions. Usually, a separate class of shares is issued to investors with these rights attached.
A good investor isn’t interested in running your company. They just want to maximize its chance of success. Unless something goes terribly wrong, you and your cofounders will still be in charge of the company, making all the day-to-day decisions.
Nevertheless, many founders grapple with the question of giving up some control of their company.
It’s important to separate the concepts of economic interest and control. As a startup raises more capital, the founders’ shares are diluted by the incoming investors. When startups raise large amounts of money over multiple funding rounds, founders sometimes end up with a minority stake in the company they started.
This change doesn’t necessarily mean they lose control over the company. An investor can have a significant economic interest in the company while having only a modest degree of control over it, but they still benefit financially when the company is successful.
By way of example, Mark Zuckerberg retains significant control over Meta (previously Facebook). He holds around 58 percent of voting stock, despite having raised billions of dollars from investors and being diluted to a minority shareholding with less than 20 percent of the company’s total stock.
Funding rounds
When startups raise money from investors, they typically do so in discrete stages, or funding rounds, that align with milestones in the company’s development.
Each funding round is linked to achieving a certain level of de-risking of the opportunity. As the company goes from one funding round to the next, the amount invested generally increases, as does the valuation of the company.
The terminology used to describe each of these funding rounds varies considerably by geography and by industry. The most common terms and their meaning are summarized in the following sections. Each section describes a different funding round.
Funding round
Typical company stage
Typical source of capital
Friends and family
Idea, concept design, prototype, or minimal viable product (MVP)
People you know who want to support you as an entrepreneur and who might not want or expect a large financial return
Seed
MVP or product in market
Evidence of problem-solution fit
Early traction in the form of product usage and ideally some revenue
Angel investors
Seed-stage venture capital (VC) funds
Series A
Established market
Evidence of product-market fit
Growth in revenue limited by capital rather than by demand
VC funds
Series B, C, D, E
Expansion to other products, markets, and geographies
VC funds, private equity firms
You can plot these funding rounds on a time chart that shows the typical milestones against which each round is raised.
The investor perspective
Why do investors invest in startups? To answer this question, we first need to look at risk and return.
Investors typically have a portfolio of investments. Each investment can be characterized by two factors:
Potential rate of return: How much money the investor could make for every dollar invested if the investment is successful.
Level of risk: The level of uncertainty about whether it will generate that return.
The riskier an investment, the higher the rate of return an investor should expect in order to compensate them for taking the risk.
Generally speaking, at the low end of the risk-return spectrum are investments such as government bonds. Property and listed stocks are in the middle. Startups are at the top.
It’s estimated that more than 90 percent of all startups fail and around 70 percent of seed-funded startups fail. So a seed-stage investor who invests in 10 startups can only expect three of those startups to succeed.
Experienced investors have no problem with accepting risk, but only if they can see the potential for a large return to compensate them for all the investments that didn’t make it.
As a guide, early-stage investors look for at least a 30 percent annual rate of return across a portfolio of startup investments. For reference, the average annual return to investors in residential real estate is around 10.5 percent.
Investors need liquidity
Investors typically don’t invest in your company for a dividend or a share of profits; instead, they want your company to achieve a liquidity event, which is also known as an exit.
An exit occurs when your company is either acquired by a larger company or listed on a stock exchange. Acquisitions are more common than listings. At this point, investors can sell their shares and receive a one-off sum. Founders, employees, and any other shareholders generally sell their shares too.
For founders, this means that if you intend to raise money from investors, you need to be clear from the outset that you’re building an acquirable or publicly listable company.
For example, you might want to build a lifestyle business or a company that you hope will remain privately owned forever. You won’t be able to raise money from most mainstream investors, such as angels and VC funds, because there might not be an opportunity for them to exit their investment.
Finally, it’s important to recognize that investors are often themselves successful founders who exited one or more of their own companies. They might want to actively support other founders by reinvesting the wealth they generated. This is especially true in more mature startup ecosystems that have large numbers of successful serial entrepreneurs.
What investors look for
When an investor considers your company as an investment prospect, they’re essentially assessing risk versus rate of return. The following indicators of failure are a good proxy for risk. The success indicators are a good proxy for rate of return. Investors score your company by considering each indicator in the following checklists.
Success
Failure
☐ Non-obvious idea
☐ Building a product that nobody wants
☐ The right team
☐ A derivative idea
☐ Intense customer pain
☐ Competing with free
☐ Scalable business model
☐ Attempting to scale before achieving problem-solution fit
☐ Large opportunity
☐ Too concerned about secrecy
☐ Timing
☐ Not seeking out the right advice
☐ Tailwinds
☐ Inherently shareable
☐ Recurring revenues
Some other factors that investors consider when they make investment decisions include:
Growth levers: Actions that translate into growth in customers and revenue, such as paid acquisition, content marketing, or partnerships. Investors want to see that the founders have identified growth levers. When you apply capital to growth levers, you should generate more growth. Investors also want founders to prove that unit economics are positive. That means for every dollar you spend pulling a growth lever, you generate more than a dollar in revenue.
Validation: You’ve validated your riskiest assumptions. For instance, you’ve confirmed what product you should build and what customers you’re building it for. You also have evidence that those customers see enough value to buy it.
Commitment: Founders need to be able to demonstrate to an investor that they’re 100 percent committed to the company.Many founders take a stepwise approach to committing time to their startup. This approach is reasonable. But when you’re ready to raise funding, investors expect you to be working in your business full time and not as a side hustle. TipBefore you contact an investor, ensure your LinkedIn profile reflects your role as founder of your company.
Risk mitigation: Investors want to see that you’ve put in place some basic risk-mitigation measures, such as:
Founder vesting to protect the company in case one of the founders leaves the company.
Employment contracts with all founders and employees, including an intellectual property (IP) assignment to ensure the company has ownership of all relevant IP assets.
Good governance practices, such as regular board meetings, even if prior to the investment the founders are the only directors.
An employee stock-option program, if you have employees, to ensure maximum alignment of interests and retention of key personnel.
Investors look for outliers
Many early-stage investors see thousands of opportunities a year. They typically invest in only 1 to 2 percent of all the companies they see.
The reason for this low acceptance rate is that investor returns follow a power-law distribution. A few highly successful investments are worth many times more than all the other investments combined. Investors know that most startups in which they invest will fail. The small proportion of startups that succeed need to generate a large enough return to compensate for all the failed companies.
This concept is one of the most misunderstood ideas in startups. This misconception frequently leads founders to underestimate the scale of success their company needs to achieve for it to be considered investable.
Let’s explore this concept further by working through a hypothetical angel investor’s startup investment portfolio.
Scenario: An angel investor’s perspective
Melanie is an angel investor. She decides to make seed-stage investments in 10 companies with an average investment of USD100 thousand in each company. These investments will take place over a period of a few years.
Melanie doesn’t know which of the companies she backs will ultimately be successful, but realizes that each company she invests in must have a chance at being hugely successful. She makes her investments with this idea in mind.
Significant research has been done on angel investor portfolios. One of the consistent findings is that on average, at least half of all early-stage investments lead to no return. This result is typically either because the company fails completely, or it grows slowly and remains a privately owned company but never achieves a liquidity event. Investors sometimes refer to these investments as zombie companies.
As an experienced investor, Melanie knows this outcome is likely for a large proportion of the companies in which she invests. Like any sensible angel investor, she only invests money that she can afford to lose.
Let’s look at Melanie’s investment portfolio and assume from the outset that half of her investments generate zero return.
Investee
Amount invested
Investor return on exit
Company 1
$100,000
$0
Company 2
$100,000
$0
Company 3
$100,000
$0
Company 4
$100,000
$0
Company 5
$100,000
$0
Company 6
$100,000
Unknown
Company 7
$100,000
Unknown
Company 8
$100,000
Unknown
Company 9
$100,000
Unknown
Company 10
$100,000
Unknown
Total
$1,000,000
$0
Research also shows that out of every 10 angel investments, on average two make a one-time return, which is better than zero but not a successful outcome. This scenario sometimes occurs because the founders know the company isn’t working out. They’re able to do an orderly windup and return the investors’ capital to them before the company completely fails.
Similarly, out of every 10 investments, on average two make a small positive return of two times to four times the amount invested. This scenario can occur when the company is acquired, meaning a small acquisition coupled with hiring the team that started the company. Again, this return is better than zero, but it’s not the outcome that Melanie is seeking.
If we now look at Melanie’s investment portfolio, we can populate nine of the 10 investment outcomes. Five failed, which generated zero return. Two generated a one-time return, and two more generated a two-time and a four-time return.
We can see that Melanie’s portfolio return from these nine investments is USD800 thousand.
Investee
Amount invested
Investor return on exit
Company 1
$100,000
$0
Company 2
$100,000
$0
Company 3
$100,000
$0
Company 4
$100,000
$0
Company 5
$100,000
$0
Company 6
$100,000
$100,000
Company 7
$100,000
$100,000
Company 8
$100,000
$200,000
Company 9
$100,000
$400,000
Company 10
$100,000
Unknown
Total
$1,000,000
$800,000
The table tells us that company number 10 must be the one that makes Melanie’s investment portfolio a success overall. It needs to make up for the startups that failed and those companies that made a small return.
How well does company number 10 need to do? We can estimate this amount by working backwards from an expected portfolio rate of return. We noted earlier that seed-stage investors look for at least a 30 percent annual rate of return across their startup investment portfolio.
If Melanie invests USD1 million and holds these investments for seven years, she needs to realize a USD5 million return on her USD1 million invested. A simple internal rate of return (IRR) calculation confirms this return.
A USD5 million return might sound like a phenomenal outcome. That’s USD4 million more than Melanie invested. But remember that she’s investing in risky startups and could’ve made a much safer return by investing in lower-risk assets.
If we know Melanie needs to make a USD5 million portfolio return, and so far nine companies have returned only USD800 thousand, we know that company 10 needs to generate a return of USD4.2 million.
That’s a return of USD4.2 million on an investment of USD100 thousand, or a 42-time return on Melanie’s investment. Melanie’s portfolio would now look like the following table:
Investee
Amount invested
Investor return on exit
Company 1
$100,000
$0
Company 2
$100,000
$0
Company 3
$100,000
$0
Company 4
$100,000
$0
Company 5
$100,000
$0
Company 6
$100,000
$100,000
Company 7
$100,000
$100,000
Company 8
$100,000
$200,000
Company 9
$100,000
$400,000
Company 10
$100,000
$4,200,000
Total
$1,000,000
$5,000,000
Some startup founders might think that a 42-time return sounds egregious, but it’s perfectly rational. If Melanie invests in 10 companies, and she doesn’t know which of them will be successful, every single company she invests in must be capable of generating something like a 42-time return.
Let’s consider what this scenario looks like from the company’s point of view. An investor return of USD4.2 million doesn’t represent the value of the entire company. If we assume that Melanie invested in the seed round, and the company then raised money from other investors, her shareholding will have been diluted. It might have gone from 10 percent at the seed round to 2 percent on exit.
If 2 percent of the company is worth USD4.2 million, the entire company must be worth USD210 million on exit.
As a startup founder, if you’re aiming to raise money from investors, you need to see a realistic path to achieve the sort of growth and scale described here for company 10.
Only if you can achieve this goal will investors see your company as a sound investment prospect.
Note
The numbers in this scenario are illustrative. Many variables influence the outcome, such as the total amount of capital raised and the time from seed round to exit.
