Investment decisions are based on interlocking variations of the induction hypothesis. This model determines when sensible investors will invest, and when they won’t. Understanding that model tells you what you need to do to get investors to decide in your favor.
Originally published 2000
The previous paper, The Tetrahedral Model, gave you a mental model for a business. This one gives you a model for getting one funded. The idea is show the kind of things you need to do, and the information you need to provide, to convince investors to invest.
Understanding The Inductive Hypothesis
Asking an investor to commit funding, or for that matter recruiting someone to join the venture, is tantamount to asking for a leap of faith. You are asking them to believe in your vision of the future. Like Columbus, you are asking them to believe that you will indeed arrive at your goal. (We’ll simply overlook the fact that Columbus was headed for India at the time…).
Eventually, it comes down to trust. When people believe in you, when they trust that you will achieve your dreams, they readily commit to the endeavor, because they believe in its success. Conversely, when people commit their time and energy to your project (in the form of either man hours or investment), then success becomes all the more likely. The question is, how do you “prime the pump” to initiate and accelerate the upward spiral of belief and commitment?
The answer, oddly enough, would appear to lie in mathematics. One form of mathematical proof is “Proof by Induction”.
There are three parts to an induction proof:
- In mathematics, this is the proposition you intend to prove. In business it’s the goal you intend to achieve. Note that the goal must be noteworthy to secure venture funding. The technology that is eventually developed must be fairly remarkable, and the potential financial rewards must be huge, so as to provide incentives. If the goal isn’t large enough to start with, there is nothing to attract risk-investors (venture capitalists). On the other hand, if you are developing a new technology, then there is too much risk to secure a small business loan. Unless you think big, you can find yourself with a risk/reward ratio that precludes investment of any kind!
- In mathematics, this the starting value. You prove the proposition for that one value. Typically, that value is zero or 1, and the proof is generally pretty simple. In business, that seed takes different forms, for the different segments of the enterprise. For the technology, it is your initial demo. For the financing, it is the initial investment. For marketing, it is that first sale, or at least a letter of intent that expresses a desire to purchase your product, when it is finished.
- The final step in the process, in mathematics, is to prove that if you assume that the proposition is true for an arbitrary number, “n”, you can demonstrate that it must be true for “n+1”. At that point, the proof is done. You’ve already shown it to be true for the number zero (or one). And if it is true for zero, you have now shown that it must be true for 1. And if it’s true for 1, then it must be true for 2, etc., out to infinity. In business, that part of the proof is the plan. Having demonstrated the proposition with your initial seed, the plan shows
In the next sections, you’ll see how the inductive method applies to the process of producing a persuasive business presentation.
Applying the Inductive Hypothesis — Specifics
In The Tetrahedral Model, we identified the major components of a successful business:
Now, let’s see how the inductive hypothesis applies in each of those areas.
As indicated previously, purpose is the driving force behind the business. Its what got you started in the first place. The purpose is the goal of the enterprise as a whole. “Unity of purpose” is therefore an important consideration at the outset. If the goal of marketing is to inform every person on the planet, but the technology under development is of use only to system administrators, then the organization will be working at cross-purposes, and a lot of time and money will be wasted.
As a technology maven, you may have noticed that when a company (or project team) is interviewing you, you have a chance to interview them, as well. It can be fascinating, at times, to listen to several members of the team talk about a project, and get a completely different story from each person you talk to. Basically, such projects have a long way to go before there will be sufficient agreement to get anything done. On the other hand, you know a project has a strong chance of success when everyone you talk has the same overall vision, and can explain how the piece they are working on relates to the final goal.
So, if the purpose is the fundamental goal of the enterprise, then the only question is whether you will be able to acquire the people and the means to achieve it. The answer to that question is once again an inductive argument.
From the standpoint of the inductive hypothesis, the purpose is the goal. the seed, and the proof, all wrapped up in one. That is the goal, is obvious. Your own belief and desire to achieve that goal is the seed — a proof, if you will, that at least one person can see and commit to that vision.
The process part of the inductive hypothesis now rests on your ability to communicate that vision. If you can do that, and make it so tangible as to seem real — inevitable, even — then it will be clear that you will be able to acquire the resources needed to achieve the vision, both in terms of people and money.
There are two parts to communicating that vision. One is simply the ability to focus on a clear, consistent message that motivates people. Do you want to scrub rocks? Or do you want to create a pristine beach with beautiful sunsets? There is a world of difference. You are the seed for the organization (which we’ll discuss next). So your ability to communicate and motivate is vital to its success.
The second part of the communication process involves making it real. It’s a matter of providing a detailed, step by step plan that shows how, after scrubbing one rock, you will eventually clean the whole beach. It shows how you’ll advertise to recruit volunteers, organize to work effectively, develop rock-polishing tools, and obtain donations to keep the scrubbers fed. It shows how you’ll scrub 10 rocks tomorrow, 100 next week, 1000 next month, and 10,000 a day in the following year. And it shows you in enough detail that it makes sense!
The following sections highlight the kinds of things you need to develop for each of the major segments of the enterprise. First, though, we’ll address the issue of trust.
At the other end of the tetrahedron lies the second most important part of the proposition — the organizational wizards who plan to run the operation. The fundamental requirement for any favorable decision — be it to invest or to join — is trust. The participants must not only be decent and honorable (and unlikely to run away with the loot), they must also be experienced professionals who have a strong likelihood of achieving the goals they have set for themselves.
In essence, the background of the people is the process part of the inductive argument. They people themselves are the seed. And the fact that they are committed to the enterprise brings a strong reality factor to the plans. This rule holds true for the marketing, technology, and finance segments of the business, as well.
When it comes to background, there are three kinds of people investors look for, listed here in order of decreasing desirability:
- Someone who has done it before
- Nothing succeeds like success. It’s hard to argue with a history of successful performance. How could you not trust such an individual to achieve their targets? They don’t need to have done it all themselves. They just need to have been involved in the effort, close enough to have seen how it works (at least the part that they will be responsible for). From the standpoint of trust, co-pilots generally get as much respect as the captain.
- Someone who has failed at it before
- This group comes in a very close second. To have done it is to understand a heck of a lot about how it works. To have made mistakes is to have learned some truly deep lessons. After my failed startup, I was licking my wounds for a long time. But to my surprise, whenever I talk about the truly horrendous mistakes I made, I find that my stock goes up in others’ estimation, rather than down. I’ve become a veteran of the battle, returned from the trenches (and I have the scars to prove it). And I can say with certainty that you have an overwhelming strong internal desire to avoid repeating the same mistakes!
- Someone who has never done it, but wants to
- Folks in this group come in a far distant third. So far distant, in fact, that they pretty much fall off the radar. It’s great to want to. It beats not wanting to. But there are so many mistakes to be made, so many ways to go wrong, that success is anything but certain. Rather the reverse. (There is of course a chicken and egg problem: How does someone get the initial experience? The best way to solve that problem is to understudy someone who is solving the kinds of problems that intrigue you. Work with them, learn how it goes, and take advantage of any educational opportunities you find along the way.)
So, in terms of building the organization, the ideal situation is to have all four of the major slots (organization, marketing, finance, and technology) covered with experienced professionals who have an appropriate track record. The earlier that all four areas are covered by at least one person — even in a part-time capacity — the better. Until all the bases are covered, the enterprise simply isn’t ripe for investment.
On the very first, though, it is unlikely that you will have all your bases covered. That’s ok. The next best thing is to be clear about the fact that you know what you need, you recognize the importance of those needs, and you are taking steps to fill them, perhaps by actively recruiting “advisors”, at the outset — people who can offer advice and expertise, with a minimal commitment. Hopefully, as you move forward you will be able to roll them into part time positions, and eventually full time.
Even with all the bases covered, though, as you grow you are going to need more than a few people. So you need to make hiring plans — how many people you are going to bring on, in what capacities, as you move downstream.
Here, the planning starts to dovetail with other areas. The development timetable is going to impact the hiring plan: As more technology is developed, there will be a need for more testers. As more is delivered, more support people will be needed. And vice versa: The number of people available will impact how many projects can be taken on.
Similarly, once the marketing efforts start to “bite”, more people will be needed to fill the demand. And larger sales efforts will be needed to fight off the inevitable competition. Similarly, the number of people available will determine how much can be accomplished. For example, it’s no good predicting $5 million dollars in revenue if a single sales person averages $300,000 in the industry, and you only have one! Even the best sales person would have a hard time reaching that goal!
Finally, the hiring plan must dovetail with the financial plans. The cash flow projections will determine what can be paid in the way of salaries. And the equity model will determine what kinds of stock options can be offered by way of compensation.
To bring it back to the induction hypothesis: the goal is how big an organization you eventually intend to develop. It must be large. Otherwise a small business loan may be more appropriate than investment. The seed is you and the people you managed to attract to get started with. The process part of the proof consists of the plan. (The experience embodied by the people in the organization may be considered as part of the seed, or part of the proof — the reason for trusting the plan — or both.
The goal of the technology will ideally be something outrageously cool. Technology developers love to build cool new things, so the spiffier it is, the easier it will be to acquire top-notch developers (assuming, of course, that the project is also feasible — that is the middle ground in which innovation happens.
The seed of the technology “proof” is the initial prototype. Ideally, it’s a low-level alpha version that is actually functional. But it could also be a purely visual demo — just pictures or animations. As long as the developers have expertise adequate to the task, and can say with a straight face that yes, they really do think they can achieve their targets, then a visual demo (aka “vaporware”) can be sufficient.
The process part of the proof consists of the development plans & timetables that predict where the development process will be at time N. Things will change, of course. But without some kind of estimates, it is impossible to do the planning that rest of the organization depends on.
Here, the ad hominum argument (argument that a thing is true or not simply because so-and-so says it is) is critical. There is very little reason for believing in a timetable put together by Johnny Wannabe, Programmer Extraordinaire, no matter how beautifully constructed the graphs are. But a timetable that an experienced professional put together after a lot of thought rates a different kind of respect.
As always, the best development numbers come from the ground up. You can ball park things by saying, “it will take 6 months to do that”. But more realistic numbers will only arrive after a couple of months of planning, in which you detail all the pieces that will be needed, figure out long each itty bitty piece is likely to take, and then add up the numbers. As an organization, the best you can do is to live with the ball park numbers at the outset, and then adopt the dates from the detailed timetable as soon as they become available (with continuing course corrections, of course).
The marketing plan will tend to be even more inextricably linked with the financial plan than development. Due to the expense of advertising, marketing costs can dwarf the development budget in some cases. It can take quite a while for sales to develop, as well. Major corporate purchases can require long-term sales efforts that take 8 or 9 months. Even advertising to consumer tends to require a few months before it starts to “bite”. (There are estimates that a person has to see the same ad 4 or 5 times before they take action on it.)
So the marketing plan must correlate well with the finance plans. It must also correlate with the development timetable. After all, it’s hard to sell it when it doesn’t exist. (Although I have it on good authority that a sales person who is worth their salt is able to do so, as much as a month or two in advance of actual delivery, by citing delays and offering additional incentives — an intriguing prospect.)
All the plans in the world, though, don’t amount to a hill of beans unless someone, somewhere, demonstrates an interest in paying cash dollars for the product or service you are selling. That sale is the seed of the inductive proof. If you can’t get one person to buy it, its hard to see how you are going to get 1200 people to buy it, no matter how fancy your spreadsheets are.
But how do you sell something that doesn’t exist yet? How can you prove that someone, somewhere actually wants what you intend to offer, and wants it enough to pay for it? The best tool for that purpose is a “letter of intent”. The ideal letter of intent will be a commitment to buy such-and-such a product, at such-and-such a price, on such-and-such a date when it is delivered. Such a letter is tantamount to a sale, and it is the strongest proof you can obtain, short of delivering the product and putting cash in the bank.
However, it is possible to achieve a similar level of proof with what I will call a “letter of interest”. Such a letter would indicate that a company or person is interested in acquiring a product of the kind you anticipate building, in some kind of reasonable time frame (anywhere from a few months to several years). If some sort of price range can be added to the letter, so much the better. If ABC corporation can say that a tool of type X would save them $$$ a year, and therefore they would plan to evaluate closely any such tools in the $XXX to $YYY price range, with the idea of purchasing one in the next 12 or 24 months, then that letter too offers a seed proof — especially if you are developing a unique technology, and you will be the only game in town!
The interesting thing about that approach is that it gives you a way to put a value on your product. In your early talks with people, you can identify a broad price range that they would find acceptable. The more people you talk to, the more you can narrow it down. That’s important, because it can be hard for an inventor to put a price on their mousetrap. What’s it worth? To the inventor it’s priceless. But the secret fear is that it will be worthless to others. (The inventor proceeds anyway but like the artist, the fear is always there.)
Investors, naturally enough, want to know how much you’ll be selling the thing for. But how do you go about putting a value on less mouse? That can be hard to do, in the abstract. But go talk to the manager of a hotel’s maintenance department. Talk to homeowners. Ask them if they would pay $X. If they leap at it, ask about a larger amount. If they’re reluctant, remind them of the value and ask again. That’s the beginnings of salesmanship (salespersonship?). On the other hand, if the reaction is a definite no because, for example, the hotel would rather live with the mice than go out of business because all their money went into buying a mousetrap, then you know you’re asking too much.
Among businesses, a 3- or 4-year payback period is the norm. If the thing will save me $X a year, it will have paid for itself after 4 years and after that, the business is making money. That’s considered a good investment. Among consumers, on the other hand, values depend on more emotional factors — a sense of immediate satisfaction, for example. That’s one reason that a better mousetrap tends to sell to the wealthy first — they pay for the satisfaction of having the latest and greatest device (and since the price point is higher, you ramp up production slowly, instead of being swamped with a million orders the first day). Once the newness has worn off, on the other hand, the satisfaction quotient drops to the value of “having fewer mice”. That’s not something you want to try selling to people who live in mud huts. That’s why it’s important to identify your target market and figure out how you’re going to reach them, or help them find you.
Since I am just about as far as you can get from a financial guru, I’ll discuss the two financial models I know a little about, and let it go at that.
Cash Flow Model
The cash flow model shows how much you are spending from month to month, and how much you are taking in. Salaries, overhead, marketing costs, and legal costs all figure into the outflow category. Sales, loans, and investment capital all figure into the inflow. Just like your home budget, your goal is to be in the black as much as possible. In fact, to meet payroll, you have to be in the black, as far as having cash on hand, even if that means taking loans to do so.
Taking loans turns out to be pretty unavoidable, in many cases. The reason is that the investment in the development and marketing consumes a lot of capital before sales are made. In addition, when you make a large sale to a corporation, it tends to take a while before the cash arrives. The typical delay is 30 days, but some corporations are notorious for extending the payment process as long as possible — out to as much as three months.
These factors make cash flow projections critical to the success of the business. Needless to say, the projections must dovetail with the plans made by the marketing, technology, and organizational segments.
The second important financial model is the equity model — who owns how much stock, who paid what to get it, and how much it figures to be worth when you go public. Having a strong equity model has a direct impact on securing investment, because it specifies the kind of return that investors can expect. In addition, the equity model helps to motivate the people you need to join the enterprise. That motivating capability has an indirect impact on securing investment — because the ability to get the people you need determines how successful you will be in achieving your goals.
When I am looking at a prospective company, therefore, I am not looking for the biggest share of the pie. Rather, I am looking for the right share of the pie. The reason: If the pie is divided up properly, there is sufficient financial incentive to cover all the important bases.
The way you put together an equity model is by comparison with other organizations to the one you plan to develop. You look at how many people they have, how much revenue they made, and how the equity was divided. You look at the company’s valuation at IPO, the initial stock price, and work backwards from there to calculate how many shares of stock should exist at IPO.
Like I said, I’m not a financial wiz. So the process of working out the detail is best left to someone with experience in that area. Here are some numbers you start with though:
- Company founders tend to own 30% to 50% of the company at the outset. That gets diluted as more investors are brought on board.
(more like 30% if “sweat equity” is the only form of investment, approaching 50% if they have put significant amounts of capital, as well)
- The initial stock price at IPO these days tends to be $15.
(That gives it a little room to go down, as well as up.)
The valuation of the company at IPO depends on what investors are willing to pay for the stock. The valuation depends on the number of outstanding shares, of course, so fixing the stock price at $15 makes it possible to divide the valuation of other similar companies by the price to determine the number of shares you need to issue by the time the IPO happens. (You can start with a smaller amount, and then split.)
From that point, there are two important details left to be worked out:
- How much of the equity goes to different levels of the company
(Top level executives may own from 1 to 3 percent of the company. Lower levels have somewhat less, and so on, down as many levels as you need to go or want to go.)
- Making sure the detailed marketing and development plan support the valuation
(It’s one thing to say the company is going to be worth $20 million at IPO. It’s another to understand that the company which had that valuation also had $2m in sales, and to show exactly how you are going to reach that $2m sales figure.)
In any investment, there is always risk. The trick is to keep the risk to acceptable levels. When starting a business, the risk that things won’t work out is real. Even with the best laid plans, things “aft gang agley”, as they say. But risk of that sort is generally acceptable.
The one form of risk that is not acceptable arises when there is no plan, or insufficient planning! Without a plan — a roadmap to guide you — there is virtually no chance of arrival!
The following table summarizes the information you need to deliver to motivate investors to invest, and to motivate others to join your enterprise. To paraphrase Lincoln, you won’t need to explain all of these facets to everyone, but you’ll wind explaining every facet to someone, somewhere along the line.
What you want to achieve.
|Your success in communicating that vision to whomever you are speaking to.||Yourself and whoever has been convinced to join your effort.|
|Organization||A company consisting of N people, with so many in each segment of the enterprise.||The hiring plan, showing how many people will be acquired in each area, when.||At least one person other than yourself who has been convinced to join the effort.|
|Technology||Super cool technology that does everything anyone could ever want.||Development plans and timetables. Research results you plan to adopt.||Initial demo or prototype.|
|Marketing||$Mm in sales, producing $N in revenues.||Marketing plan, including advertising, sales personnel, and PR efforts.||At least one sale, letter of intent or, at a bare minimum, a letter of interest.|
|Finance||Company valuation of $Mmm at IPO.||Cash Flow Projections|
|At a minimum, the time and energy that your team has devoted so far. Ideally, seed capital provided by at least one other individual who is not otherwise involved (a pure investor, in other words).|
Finally, note that all of the plans must dovetail with each other, and make sense when taken together as a whole.
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