5. Evaluating Startups for Investment (George Deeb)

Download_v2Nick Moran Angel List

George Deeb joins Nick on the Full Ratchet to discuss investment criteria & evaluation of startups including:

  • George DeebWhat key questions should a startup be able to answer, that precedes evaluation (ie. If a start-up can’t answer these questions, don’t waste your time evaluating)?
  • At a high-level, what are the categories that an investor should consider when evaluating?
  • In general, do you subscribe to a qualitative or quantitative decision process?
  • Are there any “red flags” that superceed all other evaluation criteria?  In other words, if a start-up sets off these red-flags, you will avoid investment no matter how strong all other evaluation factors are?
  • In general, do you subscribe to the philosophy that an investor must see a certain number of companies for every one that they invest in?
  • What is “the fast no” and why is it important?
  • How does one speed up their evaluation process and make faster, more-decisive decisions?
Direct-audio:  http://bit.ly/1ooHq0f


SoundCloud:  http://bit.ly/1He8w6N

Guest links:

 Key Takeaways:

 1- When considering a startup for investment…
  1. All starts with “Team.”  George would rather have an A+ team building a B idea than a B team building an A+ idea.  This is a key point that comes up time and time again as I talk with professional startup investors… and it can’t be stressed enough.  
  2. Market- Is the startup going after a market that is big enough to create significant opportunity?
  3. Competitive Set- Are there other players, doing similar businesses that have strong venture capital funding?
  4. Revenue Model-  Is there a way to monetize the business?  And have they tested the customer acquisition model for revenue to insure that there is a profitable way by which they can acquire new customers and make money doing so.
2- The Stages of Development
  1. Piece of paper -> Product
  2. Product -> Proof of Concept
  3. Proof of Concept -> Scale

Depending on where you’re at in the Stage of Development, this will determine your valuation…  so often the piece of paper ideas will have a much lower valuation than startup that has a product built and has found proof-of-concept in the market.

And to recap this term “Proof-of-Concept.”  George defined it as…  proving that there is customer demand around a particular idea.  So he mentioned having a pipeline of leads that are being converted into customers and ultimately something that proves to the investor that customers are interested in the idea, they like it well enough to sign-up for it and the entrepreneur is sophisticated enough to market it.
3- Deal Killers
We talked about what’s absolutely necessary for a starutp to be able to articulate before you spend time evaluating…
Need to show an investor what they care about, which is how much of a $ return they will get.  A startup needs to have a clear roadmap to a 10x return or higher… b/c the startup investor understands that they will only have a handful of successes out of every 10 investment they make, so the successes need to be large in order to makeup up for the losses and still provide an outsized return on the entire portfolio.  In general it seems that there’s two schools of thought when it comes to this.  Some angel investors dislike when starutps talk about exits (ie. selling the business for a return), b/c it makes them look like they’re not focused on the present and their main motivation is to make a lot of money.  I can see where angels are coming from when they say that, but I honestly think that startups discuss it b/c it’s the expectation.  You always have to know your audience and in this case the startup audience is an investor that needs to be confident in a 10x+ return..  so from my standpoint there is definitely a place in the pitch for startups to discuss how the investor makes money and what they think are potential exit strategies.

 Tip of the Week:  If you Build it, will they Come?

Below is the "Tip of the Week" transcript from the Podcast:  Episode 5:  Evaluating Startups for Investment (feat. George Deeb)
Today I want to talk about MVP and MVC.  We hear a lot of startups and investors talking about MVP (ie. Minimum Viable Product).  Typically the earlier a startup gets a product launched and is able to test it in the market, the better off they are b/c they're constantly getting feedback and are better able to prioritize changes and improvements to the product as well as better able to understand purchase motivations and demographics of their target market.  In general, I very much support this.  However, there's a misconception, in the startup world, that a product is required to make a sale and test the market.  In many cases a product is not necessary and this is what's referred to as Minimum Viable Concept or MVC.  I've seen a number of companies spend an incredible amount of their own money, investor money and time building their solution, not really knowing if it will sell, once they release it into the market.
So, the question is, how can we test sales without real products?  Well, take for instance a recent startup that I saw that was pitching a men's facial grooming product.  I won't be too specific on what it was, but know that it was a physical product that was a consummbale... so disposable after one time use.  And what was key in the pitch was that their only sales channel was over the internet.  They were not trying to sell this via retail.  I think they were basing their sales model on sort of a dollar shave club model.  So the founder was working with engineers on product development, traveling to china to meet with manufactures and (more…)

Nick: Today we have George Deeb with us. He is an investor and managing partner of Red Rocket Ventures; George, wonderful to have you with us today.
George: I’m thrilled to be here Nick. Thanks for the invite.
Nick: I wanted to have you on the podcast to do an intro to evaluation. This is probably the deepest topic we will cover on the podcast. There are many subjects that we can get into in the venture capital world; but if you fail to evaluate startups appropriately you’re gonna have some trouble.
Welcome George, I’m very excited to have you here and was hoping that we could start with a brief intro on your background and how you first got into startup investing.
George: Yeah perfect. I’m a 8 year investment banker from Credit Suisse, turned 15 year internet entrepreneur here in Chicago. I’ve been the founder and CEO of 2 different text startups. One was I Explore, became the number one adventure travel site. We had a strategic relationship with National Geographic. Venture Capital bank business that was sold in 2007 to a big European travel company called TUI.
And then the second company was a, B to B digital video technology business called Media Recall. That business got sold to Deluxe in 2010. When I sold that last business I didn’t really know what to do next. I launched Red Rocket really as a place holder to find my next CEO gig. And it developed a life, entirely of its own.
I’ve had over 500 companies reach out to me looking for help. Many are in fundraising mode, so I’m very close to the venture capital community.
Nick: Wow and that’s part of the reason why I wanted George on today. ’cause not only does he understand the investor perspective but he’s really hands-on with a lot of startups. He understands what makes them tick; what makes them work; and I think you’re the perfect person to give us this intro into evaluation. So thank you.
George: Yeah perfect.
Nick: Awright so let’s launch in. First things first, give us a flavor for how evaluation works and what you should think of when you see a startup that is interesting and exciting.
George: Awright well let’s first start with, how do you look at the right business idea first? Right we’ll focus on what makes a good business idea; and then we’re to get into the evaluation there from.
Nick: Great.
George: From a business idea perspective, I usually start with ; it all starts with the team. I’d rather have an A plus team building a B idea, than a B team building an A plus idea. You wanna look for an entrepreneur that’s got the right DNA; has got the right experience and right track record to actually pull off a project like this; it all starts with the team.
The second thing you’re looking at is, how large is their industry that they’re going after? I’ll use the travel industry as an example. Are they building something the scale of Expedia; that appeals to everybody and anybody that needs air, car and hotel? Or are they building a whitewater rafting business for somebody that wants to go down to the Colorado River? So, I’m looking for the biggest market opportunity possible.
And then with the competitive set, where are they on competition. Are they a first mover in the space with a lead to win this space; or are they a last mover, they’re coming into a very crowded market with 10 other players; and how well funded are those venture capital back startups as well. Because, you don’t necessarily want to get involved with somebody that’s up against 50 million of venture capital, that they’ll have a hard time competing with their stage of development.
Nick: mm.
George: The other things would be around, what’s the revenue model? How do they plan to make money? Don’t necessarily need the money they want but we gotta have the foresight that there is an actual revenue play here down the road; and have they successfully tested their customer acquisition strategies to make sure that they actually have a profitable way of bringing consumer into the business, and monetizing in a profitable way in relation to the revenues?
So those are what kind of defines a good business idea.
Your question as it relates to evaluation. Evaluation is very much stage dependent. So if you took the startups stage and, and you broke it into kind of 3 phases. A piece of paper to product would be one stage of their development. Product to proof of concept is the second stage of their development; and then proof of concept to scale would be the third stage of their development.
Nick: mm-hmm.
George: So where they are in that evolution the valuation is slowly moving up at each one of those key inflection points. So somebody that might just have a piece of paper, well maybe that business idea is a half a million or million dollar idea but where they are, was just a piece of paper.
If they have an up and running product, well maybe it’s a couple million dollar idea. If they’ve got proof of concept around that product well now it might be a 5 million dollar idea because they’ve actually got some traction and success are on it. So you know the way I advise startups are for any stage in your investment curve, you should be prepared to give up 25 to 35% of your equity value, for that stage of the investment. As your business is growing but each chunk o’ capital you’re coming in, that next round of investors are going to want that same 25 or 30%
Nick: And that’s very helpful ’cause in the coming weeks we’re going to be doing another show that centers on the stages of financing; what happens at each stage? Who plays where and why? So it’s a good sort of starter on the topic of the stages of investing and what traction startups have at each stage.
Okay, so from the first time that an investor sees a startup, until an investment is actually made, what are the key steps in the process?
George: I think one of the mistakes an entrepreneur makes is they first approach an investor when they want the money. The best advice I can give an entrepreneur is, if you know you’re gonna need a venture capital financing down the road; start the relationship with those target investors months earlier so that you can actually build a rapport with these guys.
And they can actually see your progress and see your traction and then when you actually do need the money 6 months down the road, you’re not an unknown commodity to them. They’ve been tracking you, you’re known; what you said you were gonna do, you’ve actually been doing.
Nick: Right, right.
George: So that’s step 1. You’re just making sure you don’t approach the investor too early.
Step 2 would be once the investor is engaged. And getting them engaged is more of an art than I science because in today’s day and age with the cost of getting businesses so low, they’re seeing thousands of business ideas thrown at them in the course of a given year; where in the old days they might have seen 2 or 300.
So to get through that clutter; for them to get through their process, what used to be a 3 month financing exercise from the time they start to the time it actually funds is now become 6 months or longer, just getting through the clutter and getting on the radar. So that’s a second complexity in the story.
As it relates to, okay, “Now you have my attention and I’m ready to start doing due diligence; and I’m ready to get a financing done”. That process is about a 3 month process.
Nick: Okay. And even prior to that evaluation process beginning what are the key questions that a startup should be able to answer to just get to the evaluation stage?
George: The first thing is, you know, often times a startup is calling and they’re very verbose in the way they’re explaining their business. I like to think we’re living in a twitter-generation.
Nick: Yup.
George: If you can effectively communicate your story in a 140 characters or less; the listener’s not going to be able to digest it fast enough. So you gotta make sure you understand what an investor’s listening for.
What do you do?
What problem are you solving?
What is the solution to that problem?
And why are you gonna win? What is your game plan and plan of attack to actually make that happen?
Nick: Yup. I’ve seen plenty of startups that can’t articulate that or can’t answer those questions. And you can’t start the conversation without them.
George: Well just yesterday I had an email introduction from a complete stranger. So they broke rule number one, they didn’t come in as a referral
Nick: mm-hmm.
George: So somebody I know that I trust; they came in as a complete stranger and they hit me with literally two pages of single spaced email introduction.
Nick: (laughs)
George: And they didn’t get to the introduction of their company, their concept until the middle of the second page. And it’s like what is this person thinking? They’re never gonna get an investor’s attention this way.
Nick: Wow! Well hopefully you can help some of these startups out, with that at Red Rocket. At a high level, and we’ve touched on some of this, but what are the categories that an investor could consider when they’re evaluating?
George: First thing is that an investor is trying to figure out how they’re gonna make a 10 times return or more,
Nick: Yup.
George: On their invested capital. So most startups come in and they’re focusing on the fundraising from their perspective. And they’re trying to figure out, “I need this amount of money to do these technology improvements”, or “this sales team” or “this marketing effort” or whatever it is.
The speech is all about them and what they plan on doing with the capital. What the speech needs to be is, “I can turn your dollar investment into a $10 or more investment return”.
Nick: Yup.
George: “With the following sequence of events in the coming years”. If you can’t clearly lay that road map to a 10 times or higher return the investor’s just aren’t gonna focus; at least in this early stage space.
Nick: Got it. So you talked about return and a ten times return. Can you give us a sense for why investors should target 10x or a 30x or 100x; and eventually what does the portfolio look like? So I fast forward a few years; you’ve got an angel investor or vc fund that has a portfolio of investments that they’ve made. What is the general expectation?
George: In the venture space, in the early stage community that we’re kind of operating in, an investor’s gonna expect that if they make 10 investments, one is gonna be a hit. Call it material overturn on their investment. A couple will either get their money back or be a double on their money. And then the rest of them are gonna go outta business.
So the reason that they need to get to a 10x return for any deal that their looking at is ’cause they know that when the portfolio plays itself out, the venture capital returns are gonna end up somewhere in the 40 to 60% a year range; understanding that many of them are gonna go out of business along the way.
Nick: Yep. So in general do you subscribe to a qualitative or quantitative decision in evaluation process when it comes to start up?
George: I think it’s a good mix of both to be honest with you. Now I’m a very data driven guy. So I’m all about the numbers and how hard is the industry and how quickly is it growing; and what’s the revenue model and what’s the cost of acquisition.
So I love the data. But at the end of the day you gotta go with your gut. And sometimes your gut may override the data ’cause you know this is a big idea. They may not be effectively communicating it; or they’ve got some challenges in the way that you can help them get through and you gotta bet on the bigger ideas with the best entrepreneurs and hopefully you made the right pass.
Nick: mm. I read something recently that was gaging kind of execution versus the brilliant idea and the power of the idea. Do you have any thoughts on the balance; and what’s most important from your perspective when you see a startup?
George: You hit the nail on the head. Execution is the Holy Grail here. The devil’s in the detail on how it actually goes. And the reality is things never go to plan. So we know that going in, what actually happens in the next couple years is not exactly what you think it’s gonna be up front.
Nick: Sure.
George: So how well is that entrepreneur pivoting through their development; and what are they doing to get through the potholes and the hurdles that get put in their way? So to me execution is almost twice as important as the idea. Because the entrepreneur that knows how to break down those walls and build those businesses and get through it are the ones that are gonna win.
Nick: In my own process I use a red flag disqualifier or across a range of different criteria when it comes to startups. Do you agree that there are red flags that may supersede other evaluation criteria? In other words if a startup sets off these red flags, you’re gonna avoid the investment no matter how strong all the other evaluation factors are.
George: It’s an excellent question. I think the number one red flag is – how well does the entrepreneur listen? Because sometimes the entrepreneurs are so headstrong on their particular idea and they don’t listen to any other input from the hundreds of mentors, or advisors that are around them that are telling them, “We’ve lived through these battles before. We know you’re about ready to drive off the edge of the cliff.”
But if they put their head down and they close their ears to any input or guidance, that’s usually the first red flag that an investor’s gonna look for. That they don’t wanta back somebody who’s not gonna listen. We don’t want to necessarily run their businesses. We’re not here to tell them what to do but we want to make sure that when we present some validated facts and concerns that they’ve actually listened, thought about it and tried to adjust it.
Nick: Part of the challenge I think is, if they can’t listen to you as an investor, are they listening to their customers?
George: Excellent.
Nick: And so many startups that I’ve seen have success, have gone through a major pivot; or a transition or a left turn at some point. And the primary reason for that is, the customer spoke to them and said look I prefer X instead of Y. So moving on, in general I like to ask people this; but do you subscribe to the philosophy that you need to see a certain number of investment candidates or startups, for every one placement or investment that you make?
George: I wouldn’t say I have to see 10 before I invest in 1. If that one idea is a good idea and they check off all the boxes that I’m looking for I’ll cut that check into that 1 company without having to see another 9.
The reality is, it takes 10 before you find that one that you’ll actually cut the check into.
Nick: Yup. Can you tell us what the “fast no” is and why it is important?
George: You don’t want to waste an entrepreneur’s time. Fundraising is a cumbersome process for the entrepreneur and if you know you’re not gonna do a deal you don’t wanta waste their time or yours in the process.
So the sooner you can give them the bad news, the better, with a better feedback on why it’s bad news for them. What are they doing wrong? What do they need to address so that can go address those issues. One’ll be the better it’ll be for their business; 2, the better it’ll be for their fundraising efforts; so that, at least they can prepare for that next investor and address those issues ahead o’ time.
When I first started this process about a year ago I was meeting with, and interviewing every startup that approached me or emailed me. And I quickly realized that it was such a waste of their time and my time. So fortunately I put together a process where I can weed ‘em out very quickly, very easily often through email depending on their answers to certain questions.
And for them, they get clarity too on what it is they didn’t fulfill. And I’ve had startups come back to me and say, you know, “we addressed bullet B that you had an issue with”. Which is nice, if there’s a disqualifier and they can come back and ah, make some traction on that then, helps everyone involved.
Nick: How does one speed up their evaluation process, ’n’, make faster more decisive decisions?
George: The better prepared an entrepreneur is with their materials that investors are gonna be looking for, the faster the process will go. So if an entrepreneur is a seasoned, serial entrepreneur; they’ve gone through this process several times, they know the documents that someone’s gonna be looking for and it’s easily accessible and prepared in a format that we can digest it, then that process is gonna go faster.
If you’re dealing with a first time entrepreneur, they’ve never prepared a data room before, have never gone through this process they don’t know what to expect. When we make our first due diligence request and it’s a, page full of bullet points of documents we’re looking for and all their old contracts or whatever it is, that’s gonna take time for them of track down all those materials and if they can prepare for that process ahead o’ time it will go much faster.
Nick: So good segue. Are there any recommended resources you have on evaluation, from the investor perspective? So anything out there that investors can look to give them some base line and some framework to help them approach evaluation better.
George: There’re so many public data resources out there today that can give you a sense to whether or not the company is heading in the right direction and so a few examples would be. Let’s say you’re starting with a consumer startup. How well followed are they in Facebook or twitter? How many fans do they have? How quickly is that fan base growing? What are those people talking about in their communication channels in the community. That’s one data point.
The second data point is crowd funding has become a useful tool for entrepreneurs. So if somebody goes to raise money from Kick Start or Angel List or Gusto wherever it is. There are communities of investors that are rallying around these ideas. How quickly is that community building? And how much money has already been communicated? There’s safety in numbers.
If you see the, the tidal waves starting to develop around an idea, there’s probably a pretty good idea there.
Nick: Interesting. Can you tell us more about what you’re up to at Red Rocket Ventures?
George: Red Rocket has really got two businesses it focuses on; Red Rocket and Ensemble. I’ll talk about Red Rocket first.
Red Rocket is bringing startup, consulting, fundraising experience in shared executives to startups. The shared executive piece is the most important because we feel they need the brain power that comes with executives like ours but they can’t afford it. So if they wanted that brain full time that might be a $250,000 a year person that they don’t have the resources to afford.
But if you took that executive and you split him into 5 parts and he worked for 5 different companies on 5 different days for the week, you’re getting access to that same brain for $50,000 that would normally have cost you 250. So we’re getting a lot of traction and excitement around that shared executive program.
As it relates to Ensemble; we launched Ensemble as a one-stop-shop digital-services-suite for entrepreneurs; for everything they need to strategies, fund, develop and market their startups. Powered by an all-star awarding winning cast of digital agencies that have been curated down from the hundred that we interviewed to pick the 5 that we wanted to launch with,
Nick: hmm
George: That were prose in technology development, search engine marketing, social media marketing, public relations. The things that are important for startups to get them off the ground and that’s been a, a very successful product for us.
Nick: Always a big challenge I find, that there’s a great opportunity, good startup but they have their weaknesses. Everyone has their set of strings and maybe it’s not digital marketing; maybe it’s not SEO or SEM. And it’s always hard for me to find who are the good agencies or the good resources in town to fill that gap. There’s plenty of people out there offering services but it’s hard to distinguish the good ones. So nice service.
I want to touch on your executive service as well. Does that focus around a function or a discipline? Do you tend to deploy more financial folks, more operations folks? Is it marketing focused?
George: In terms of supply, we’ve got people that are marketers for CMO positions; or technologists for CTO positions; finance guys for the CFO positions; operating guys for COO. So it doesn’t really matter what the O is, we’ve got a network of guys that can fill those positions.
We tend to get our most request around sales and marketing. those are the areas that they’re struggling with. They’re trying to scale up the revenues. They don’t necessarily know how to do a consumer marketing launch. Or they don’t know how to build a sales organization for a B to B company.
So we get vast majority of our calls are for sales and marketing.
Nick: So, I’m passionate about Chicago; I grew up out here; I’ve been moving around the country for a number of years but found my way back about a year ago; and was very pleased with the vibrant technology seen here; the startup hubs that exist downtown like Eighteen Seventy-One. So I’ve got my opinion on it but can you tell us what you think of the current startup environment in this area and how it has changed?
George: You know the biggest support I can give is that I wished I had this eco-system in 1999 when I was launching I Explore.
Nick: (laughs)
George: The ecosystem is boomed in the last couple years and a couple things that have driven that:

I kind of use 2008 as an inflection point. That was the launch o’ Groupon. Groupon built a $2 billion company and in a couple years period of time it got a lot of other entrepreneurs excited saying, “CHey listen. I wanna do that too.” Built in Chicago has been tracking that a startup is launching every single day of the year.

So there are hundreds if not, thousands of startups that have been launched in the last couple years. And the ecosystem to support those startups has gotten better and better with each turn of the iteration. So you mentioned that some of the shared spaces like Eighteen Seventy-One and others; Tech Nexxus would be another; for later stage companies there’s Catapult. And maybe some less formal structure too for shared office spaces like Industrious and some of these other places.

So there’s a way for these entrepreneurs to engage with each other that’s number 1.

They’re a bunch more events to get people engaged with each other, the Technory events, the Built In Chicago events, that brings the community together. Or they can actually find and engage with others. The venture capitalists have gotten more aggressive in investing in earlier stage, seed stage series; a kind of money where historically Chicago had been talked about as being a series B city.

The universities are getting more organized in their entrepreneurship activities. I think a key data point to talk about is, there has been a record number of Silicon Valley or coastal VC firm lead transactions for Chicago based companies that did not require those companies to relocate to the coast. So there have been maybe 25 or 30 very large venture capital finances in excess of $10 million that the outside money is now coming into Chicago. They’ve seen the success and they realize there’s a lot of great startups coming and they want to play a part in it.
Nick: Great to see. So if we could cover any topic in venture investing on the podcast, what topic do you think we should cover and who would you like to hear speak about it?
George: That’s an excellent question. I would say I think the biggest mistake that we make in the startup world is the entrepreneurs are so focused on their product, their website their mobile app, whatever it is; that they really don’t have the foresight to proof a concept. And as a venture investor and in a network of venture investors proof of concept to us is almost more important than the product is. So somebody has got to teach the entrepreneurs to look earlier in their growth curve towards their sales and marketing activities. The guidance I give an entrepreneur is, “I wouldn’t invest $1 in writing your code”.
Until you know you’ve raised enough money, not only to code the product but to do your initial sales and marketing test on the back end so you can do some test marketing with Google their Facebook or twitter.Higher a sales guy and have some momentum come in from your sales process. So that when you walk into that investor you can check off all the boxes that yes I have growth in my visitors or revenues base; yes my pipeline is growing; yes I’ve got the following 5 marketing tests that I have done and I need money to accelerate a proven initiative instead of experimenting with something that’s unknown.
So that would be the topic that I would focus on. And you know I would look at some strong proven serial entrepreneurs that have a deep experience in doing, marketing and sales for these early stage businesses to teach these entrepreneurs what they need to be thinking about well up front before they even get started.
Nick: So you’ve touched on this a number of times; provided some great color on it; but very simply could you define what proof of concept is.
George: Everybody defines a little bit different but I think of it in terms of proving that there is customer demand around a particular idea. Maybe the website traffic is rapidly accelerating month over month. Maybe it’s a pipeline of leads is developing around a particular idea. Maybe those leads are turning into contracts, there’s a bunch of customers that are iigning up for a particular product.
It’s something that can prove to an investor that people are interested in this idea. They like it well enough to sign up for it and the entrepreneurs are sophisticated enough to market it, to get them customers that’ll actually cut them a check.
Nick: Perfect. Let’s finish up with for someone new to startup investing, what advice would you give ’em?
George: I feel it for all these people that are jumping into crowd funding that have never done this before. Don’t invest your life savings in one idea. If you don’t have a diversified portfolio strategy, you’re gonna doomed from the beginning because a startup typically has a 1 in 10 chance at success. And if you bet on 1 of the 9 companies that’s not gonna be the home run you’ve just lost all your capital and your savings. Make sure you know you need a diversified portfolio. Make at least 10 investments so that you know, as company’s go out of business and they don’t get through their proof of concept, or can’t continue to get their funding, that you’ve get enough other guys in the till that can get through that process and can achieve their scale and achieve success.
Nick: So what’s the best way for listeners to connect with you George?
George: The best way is to go to our website. The Red Rocket website is Redrocketvc.com. Feel free to email me, my email address is George@redrocketvc.com
Nick: Excellent. So follow him on twitter at George Deeb or check out the blog at RedRocketvc.com. George thanks for doing the podcast. Hope we can connect with you again sometime soon.
George: Thanks Nick, it’s been great fun