Fundable V/S Viable. The Demon of Scalability

There are two types of Startups. Fundable and Viable.

Understanding the difference between the two can really help save entrepreneurs a lot of time and resources.

I got my lesson thanks to a swift kick in the backside and a smiling, sadistic VC who sat across the table tearing apart every presentation slide of mine.

My Business Plan was regarding a kind of Cafe. 2005 was one of those years when you couldn’t turn over a business newspaper without tripping over a giddy cafe/coffee/hangout article.

As a young manager in a five star hotel and a precious degree from one of the best IHMs in Asia, I pretty much felt like what thousands of young studs feel when they pass out of premier B-Schools. Super Confident, Brash and with a firm belief that my B-Plan was the 11th commandment. Flawless Gospel.

The presentation started with 3 tired stuffy suits sitting in front with the first question of the day ‘How long is the presentation?’ I said about 30 slides. They gave me a look of surrender and disgust.

My presentation lasted about 5 minutes. I had planned for 45 mins. After all my B-Plan would change the world.

I knew it had bombed. My presentation was pathetic and my plan was a ship with more holes than hull. But back then I was stunned in disbelief. How could these middle aged men not see how revolutionary this idea is?

I made many mistakes that day. I will discuss them in future posts. But this post is about the biggest hole that negated all good things about my plan.

My plan, with a little spit and shine was definitely doable.

It would probably be profitable in the real world. But it wasn’t fundable.

 

Whats the Difference?

At the end of the presentation, one of the VCs walked up to me, took me to coffee, and explained the difference in passing.

Over the last few years, this difference has become crystal clear to me.

The primary job of a VC is not to ensure the success of startups, it is to ensure that people who invest money in their VC fund get great returns. A VC is essentially a fund manager, where the fund happens to only invest in young startups.

Now to invest in startups is very risky, even the better ones ultimately fail. Hence the returns demanded must also be great.

Its the basic ‘risk is inverse to return’ theory that works here.

VCs know that out of the 10 startups they invest in, 5 will fail, 3 will do moderately well and 2 will be superstars (This is just an example, most VCs in India will have tears of joy in their eyes, if these numbers were their own.).

So they need to make sure that their 2 superstar startups give enough returns to cover the loses from 5 failed startups and return a good profit.

In essence, they recruit hitters for their cricket team in 20-20 matches, so that even if most get out due to risky play, some will end up making centuries to cover up for the rest. Hence resulting in an overall win.

Now that means, that unlike mutual funds which look at returns in percentages, VCs look at returns in multiples.

If they invest Rs. 100 in ABC, then ABC should return Rs.2000 when the VCs exit (sell their stake in ABC to someone else). Hence the return of 20X. This means that the valuation of the company should grow by 20 times in the 2-3 years of their investment.

I will discuss these mechanics in greater detail in the future.

So how does a company rocket 20 times in valuation? Now there are lots of methods to value a startup. Some are pretty standard and most are outrageous.

However, growth in valuation, at its core depends on how fast a company can scale up. Which means, how fast can a company attain eyeballs, customer attention, usage, revenues, items on sale etc.

I will also discuss scaling up in a future post. However for now scaling up can be defined as the increase in reach, revenue, operations, customers etc by a company. In short how much growth, usually in revenue or customers, is the company showing

And the lesser the resources/time required for a company to scale up, in a potentially large market, the better the valuation of a company.

 

Example

A website can theoretically scale up to be seen, viewed and used by millions of people just by getting bandwidth and server infrastructure issues sorted out. It will probably require a limited tech team and a bunch of content writers. This doesn’t take as many resources/money to do as the below example.

Now consider a cafe. A cafe at any point of time can seat say 100 people. So at max it can service 300 people a day (lunch, evening & dinner). Lets say the cafe becomes ridiculously popular and we need to expand, in all probability we will have to start another cafe to scale up revenues.

This is very capital intensive. Hence it is has scaling issues.

And since VCs are smart, they would rather put money in a website which services millions of people and with little money can service millions more, than to put it in a cafe which services just a few thousand.

It is not surprising then, why they call such money (VC funds) as smart money.

And this smart money probably decided to fund a website rather than my cafe.

Bastards.

(I have discussed scaling up, VC funds and the difference between scalable businesses. Stay tuned for the next post. Fundable V/S Viable. The battle of startups)