different options. Have they thought about what else they could do with the technology and the skills they are cultivating? For a software startup, a potential investor might also ask how tightly the code is tied to a particular hardware or software platform, and how general-purpose the functionality of the code is.

8. Potential for a Large
investor Payoff

A startup wanting more than “angel investors” or “bootstrapping” with the help of friends and family should offer good prospects to professional investors for a significant payoff within a time frame that is typically no more than seven years. Venture capitalists often look for >20% annual returns on their portfolios, so they are looking for big winners. Not surprisingly, they tend to give most of their money to the better startups, which often do not need money to survive but need investment to get big fast.

It is impossible to know in advance
which firms will succeed, but the eight
points discussed in this column form
a framework to inform this murky
question of potential investor payoff.
For many venture capital firms, the
market opportunity has to be large
enough for the startup to become
worth at least $100 million. The busi-
ness model must demonstrate how to
scale up sales while maintaining some
advantage over the competition. Scal-
ing can be relatively easy (for example,
for a packaged software product com-
pany, although competition is fierce),
relatively difficult (for example, a SaaS
company that needs many customers
paying those small monthly fees), or
extremely hard (for example, a profes-
sional services company that is costly
and time-consuming to grow because
it must hire and train so many people).
Automated horizontal services deliv-
ered via the Internet, (for example,
Google, LinkedIn, Facebook, Pandora
Radio, Spotify, FourSquare) can scale
quickly because of platform dynamics
and network effects (see “The Evolu-
tion of Platform Thinking,” Commu-
nications, Jan. 2010). Still, there are
no guarantees these firms will build a
profitable business or go public. None-
theless, a large payoff might still come
from another “liquidity event” in addi-
tion to an IPO such as selling out to a
larger firm. We can estimate the poten-
tial value of such deals by using the re-
cent sale prices of comparable startups
or the market values for comparable
firms that are publicly traded.

Conclusion

Of course, success and failure are easy to explain in retrospect but difficult to predict in advance. Potential investors must therefore ask, with each of the eight points mentioned here: What can I know and how early can I know it? Would-be entrepreneurs also should think carefully about the items on this list. Unforeseeable factors such as chance events and timing affect all firms. But those startups that can objectively evaluate their potential and improve their weaknesses should be able to increase the possibility of their success.

 

References

1. Christensen, C. The Innovator’s Dilemma. harvard business school Press, boston, 1997.

2. gage, D. the venture capital secret: 3 out of 4 startups fail. The Wall Street Journal (sept. 19, 2012).

3. grove, a.s. Only the Paranoid Survive. Currency/ Doubleday, new york, 1996, 30.

4. Porter, m.a. Competitive Strategy. Free Press, new york, 1980, 3–33.

5. roberts, e.b. Entrepreneurs in High Technology: Lessons from MIT and Beyond. oxford university Press, new york, 1991.

6. roberts, e.b. and eesley, C.e. entrepreneurial impact: the role of mIt—an updated report. Foundations and Trends in Entrepreneurship 7, 1–2 (2011), 1–149.

 

Michael A. Cusumano ( [e-mail]) is a professor at the mIt sloan school of management and school of engineering and author of Staying Power: Six Enduring Principles for Managing Strategy and Innovation in an Unpredictable World (oxford university Press, 2010).

the eight factors framework and discussion is adapted from m.a. Cusumano, The Business of Software.

Free Press, new york, 2004, 195–214.

Copyright held by author/owner(s).

of course, success
and failure
are easy to explain
in retrospect
but difficult to
predict in advance.

milestones must happen in a time-frame consistent with the available funding. It is impossible to predict whether or when a new firm will actually make any money. But investors need to be extremely wary of business plans that call for many tens of millions of dollars and years of R&D and marketing before the venture is expected to generate any revenue. When too much time and money are required, too many bad things can happen: New competitors can enter and established firms can counterattack. Technologies can become outdated or government regulations can change. Moreover, a venture that has to keep raising new rounds of funding often leaves both the early investors and the entrepreneurs with little equity. Once the startup becomes financially desperate, later investors can impose draconian funding terms. Promising MIT startups such as E-Ink in electronic displays, and A123 Systems in batteries, turned problematic in this way, as did Akamai, which took a long time to build what is now a great business in digital content delivery.

7. flexibility in strategy
and technology

Investors look for focus in a startup because most have limited resources and time compared to large, established firms. However, most startups also need to demonstrate flexibility—in strategy, business models, and technology. Startups often get the product strategy and the business model wrong the first time around. Even with multiple chances, they often get the second and third times wrong as well. So both focus and flexibility, which seem contradictory, are often critical to success. The right formula is likely to emerge only over time, through trial and error, rather than through deliberate planning in advance.a Startups need to focus their resources on a particular approach, but then be prepared to change course or “pivot” quickly if the initial strategy is not working. To gauge strategic flexibility, investors should talk to the founders and the management team about a See, for example, H. Mintzberg, Crafting strategy. Harvard Business Review, July–August 1987, 66–75.