Let’s simplify and say there are three types of company.
Startups are the first type. They’re brand new fledgling businesses. They might not be profitable yet, or even have a product. There are lots of them, but you don’t hear much about them. That’s because the vast majority of startups fail.
Growing businesses are the second type. These companies have just “flown the nest”, to stick with the terrible avian metaphor. They’ve started to turn a profit, they have a product, and the elements are in place for fast growth.
Mature businesses are the third type. These companies’ growth days are behind them. From here on out, they exist to provide a steady stream of dividends to their shareholders and employment to their workers.
Today I want to talk about investing in startups.
The rewards from investing in startups can be huge – back the right company at the right time and you’ll make pots of money.
But investing in startups is not easy. Like I said, the vast majority of them fail.
The problem comes from a shortage of information. By comparison, when you’re investing in growth companies you’ve much more to go on. You can see how profits have changed over time… whether its management looks after shareholders… how its products are performing in the market.
And to be honest, growth companies are my bread and butter. I like that part of the market because the returns are much bigger than with mature companies, and the “pickings are richer” than among startups. It’s in the sweet spot.
But that doesn’t mean I don’t invest in startups from time to time. Sometimes, you can’t turn down an opportunity. This month’s issue of The Penny Share Letter is all about one such company.
So today I want to tell you the single most important thing about investing in startup companies.
The turning point
In any business, but especially for startups, there’s a tension between growth and profits. Obviously every business would like both. But it has to prioritise one over the other.
In the very earliest stage of a business, in the startup phase, it’s important the business prioritises profits over growth. That means it should tinker and experiment with different business models. It shouldn’t be too fixated on growing straight away. Its goal is to hit upon a business model that really works. Once it hits on that formula – what’s called “product/market fit” – the time for tinkering is over.
Once the company has found product/market fit, its job is to scale as fast as possible. Then it can prioritise growth over profits.
Here’s how Marc Andreessen describes product/market fit:
“Product/market fit means being in a good market with a product that can satisfy that market.
You can always feel when product/market fit isn’t happening. The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of “blah”, the sales cycle takes too long, and lots of deals never close.
And you can always feel product/market fit when it’s happening. The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.”
Basically, if I’m investing in a startup, I make sure that it’s already got a product/market fit. I make sure that its product is proven. I make sure the company has customers. I make sure that revenues are growing quickly.
After the company has got its product / market fit, it can prioritise growth over profits. It can plough money into new hires, marketing, whatever it needs to scale up and bring its product to more customers. It can do that safely because it knows the product fits the market.
Andreessen again: “Carried a step further, I believe that the life of any startup can be divided into two parts: before product/market fit and after product/market fit”.
The bottom line is this: I’ll happily invest in an unprofitable startup, provided it’s already found its product/market fit, and the reason it’s unprofitable is that it’s spending money on scaling up.
The company I’m currently researching is a perfect example. It’s landed big contracts from blue-chip customers here in the UK. Now it’s spending big to bring its product to the rest of the world.
I’ve mentioned it in Risk and Reward before – it’s the artificial intelligence company I alluded to in one of last week’s articles.
If you’d like to back promising startups, you can take out a trial subscription to The Penny Share Letter here. The new issue will land on your mat next Saturday.
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