The Three Cases Posted 2024-December
I have written a few business cases and I am on the receiving end of many pitches. Here’s how I structure my thinking about deals and companies. Others certainly have different frameworks – I don’t believe there is anything proprietary about this. It just works for me.
Presentation tip: You cannot cover all of this in detail in a pitch, especially if all you have is 5 minutes! Don’t try. Pick a highlight to cover, and give confidence you have the rest covered. Your job is to get people to want to have a follow-up discussion. Details can be discussed there.
Presentation tip: The least important thing to cover in a pitch is how your innovation works. Founders (especially founder-engineers) love to talk in detail about it. Don't do that. This is a business discussion. Allocate your time appropriately.
My structure comes in three parts: The Value Case, The Business Case, and The Investment Case. Let’s look at each in turn.
The Value Case (How does the customer make money? What is the Value Proposition?)
Do you have something which creates economic value (defined as some economic benefit for some set of customers)? Is this unique and protectible enough that you can sustain this against substitutes and competition?
Seems obvious: invent a better mousetrap and the world will beat a path to your door, right? Unfortunately, that’s a common, and very naïve, view. Let’s take a simple counterexample. Suppose you do invent a better mousetrap, and spend the time and money to patent it. Then, a large company knocks it off. They have cheaper manufacturing, enormous scale, channels to market, and money for marketing. But you have a patent, right? So sue them. In several years, after $10,000s in legal fees, you may win. Or not. In either case, they have won and you are out of business. Oops.
So, it’s important to have a much broader perspective on how you will gain and maintain an advantage in the market. Perhaps you lock up the cheapest source of a key raw material, or the best manufacturing. Perhaps you *don’t* patent, instead keeping trade secrets. Perhaps you create auxiliary services that unlock the value. Perhaps you create/own the channel. (Ever heard of a book store called Amazon? Their success is not about unique books!) There is much more to value creation than inventing and patenting.
One more thing: a lot of your potential investors will be engineer-trained or engineer-adjacent. We love technology and you will be tempted to go into detail on how your stuff works. Don’t do that! Give us a view of the customer's problem. Have a clear understanding of the value you are creating for them by solving it, and inspire confidence that you have some uniqueness that you can protect. Your CTO can cover the technical details during diligence. (Yes, I said this above. However, this error is so common that this caution bears repeating!)
A long time ago, I was taught a framework for writing a Value Proposition statement. It’s a nice way to organize your thinking and make sure all bases are covered. Please feel free to use:
For <defined set/segment of customers, preferably naming a few>,
we provide <solution> to <problem that harms economic value>
that, unlike competitors/substitutes <X, Y, and Z>,
delivers <lower cost|better quality|higher productivity>.
The Business Case (How do you make money?)
If only you could craft the perfect pitch, right? Nah. For early stage companies, it’s really not worth spending a huge amount of time on the spreadsheets: everything is an assumption, most are unproven, and a lot of stuff will happen over the next 5 years that you can’t predict. I am not saying to spend no time on projections, but realize that you need to get to order-of-magnitude accuracy. Also – bottom-up market sizing is not credible in early stage companies: at best, the number of customers and the price you can charge them is a WAG. It’s based on assumptions which cannot be justified. Top-down market sizing - i.e., "The market is $6T and we'll get 1% of it." - is equally bad. Size the market by the value you are creating, and the number of potential customers you are creating it for. Bonus points if you have some ideas on how the value created will be divided among you, the customer, the channel, and partners.
And – related – it’s not worth it to do the sort of deep diligence that’s done in later rounds. If a prospective investor produces 15+ page diligence reports on Preseed companies… well… you perhaps want to find other investors. One group I know of is a pay-to-play: they charge the entrepreneur to do the valueless deep diligence! Startups willing to pay that are strongly contraindicated for other investors.
For me, a business case at the Pre-Seed/Seed stage comes down to a few simple questions:
How are you going to monetize the value you are creating?
How much of the overall value created will you capture?
Is the market big enough that it’s worth it?
How will you defend your position in the value chain?
How will you deliver/manufacture?
How will you build the top line? (GTM, RTM, CAC)
Can you sell, or hire someone who can?
Note that these questions are all driven by business strategy. Do you focus on one customer set or another? One geo or another? Product, software, or services? Who should you partner with (and what’s in it for them)? Will you do retail, online DTC, distributors, VARs? The worst answer to these is “all of the above”. No one believes you can do everything – trying is a road to bankruptcy. The second worst? “Build it and they will come.” The third worst? <Blank Stare>. Let’s explore how to answer a bit better. Think about these things before you pitch – be prepared for these questions.
Story time: One of my invested companies was doing a follow-on bridge. The pitch went a bit sideways, with mixed feedback. What became apparent as I summarized the feedback for the CEO was that he’d done a very good pitch about product development, but not nearly enough on the business strategy… the “how will we win in the market”. We worked on a new deck, which he repitched and got the investment.
Also note that you may not know the answers to all of these questions at such an early stage. That’s OK, even expected. Don’t try to fill the space with some BS answer. What you need to demonstrate is:
That you acknowledge that these are things you don’t know but need to find out
A hypothesis that lets you get started (or ask the person that asked what their hypothesis would be)
A process or set of actions (including timing) to test that hypothesis, OR
An idea of how you can build a flexible/agile enough business that it won't matter
A plan to get to answers without running out of cash
The last brings up something important. You will frequently be asked for “use of funds:” What will you do if the investors write checks? The wrong answer is something like “36.4% will be spent on sales and marketing”. (Yes, I have seen that sort of thing.) The right answer is to outline the costs of testing your hypotheses. Ultimately, I want to see the milestones you will achieve, including what you will have learned through market trial, in order to raise later funding to get to the next level. When I say “traction,” I mean “evidence of positive answers to these basic business questions from customers.”
A word about updates: this is not school and investors are not teachers looking to give you bad grades. Once they invest, you have their money already – it serves no purpose to hide the unvarnished truth from them. And remember: investors are incented to help you succeed, and most are looking for a chance to do so. One of the best ways to tap into this is by sending regular (quarterly, or even monthly) updates to all of them. Celebrate the accomplishments but do not hide the challenges. And make an ask – “if any of you know X, please let me know!” I track the updates from my investments and I always help if I can. A CEO that hides by not sending updates with bad news, is a bad CEO... one who will need a bridge round when they don't get to their milestones, and will meet a chilly reception from surprised investors. Don't be that CEO.
The Investment Case (How do investors make money?)
Very little is out there, that I know of, that discusses the investment case… why investors invest in a given deal and, in fact, why they are investors to start with. Perhaps the answer is obvious, although given some of the pitches I’ve seen, a good number of people lack the empathy and understanding to effectively sell investors.
There are some people who are just so wealthy that they like to spread money around. I am not that guy. (I wish.) And there are some people who make investments for nonfinancial reasons, for instance, the triple bottom line. Often they are not far from making grants or giving charity. This is a wonderful thing! (Ask any company that’s won a grant!) Here, though, we are discussing investors, and investors require a return, preferably a risk- and time-corrected one.
That sounds simple and obvious, and yet – I repeat - I see pitches which betray a complete lack of understanding of this on the part of the founder. Mostly, this comes down to two things:
1. Yes, your company will be very valuable some day and sold for boatloads of money. However, it’s not worth that today when you’re asking me to invest. I am buying an option on that future value, not the future value!
2. VC’s depend on a model where one portfolio company does 10X, one or two do 0.8-3X, and the rest go to zero. You believe your idea is the 10X one… but those odds are against that being the case.
How does this show up? The most obvious is in valuation. As mentioned above, I have seen a company with <$1M in ARR have a $40M+ cap. That means I would be buying in at a $40M valuation in the future. I am not an investor in the future; I am an investor now and that company is not worth $40M now. Worse, it implies that the company will exit for $400M (by 10X rule of thumb) some time after that, without raising money to dilute me. C'mon man!
OK, but there’s a discount, right? 10% OK? From my perspective, I can put the dollars into Treasuries – risk free – and earn that much in 2 years, with liquidity any time I need it. Why would I take the (illiquid) risk on your company? Believe it or not, a good number of entrepreneurs never ask themselves that question, or believe so much in themselves that they don’t think it’s worth asking.
I also see it in choice of security. Simple Agreement for Future Equity (SAFE) is very popular. And it sounds great - who needs a lawyer and an N-page equity agreement when you can have “simple?” Well, that brings us to #2. A SAFE is simple because it is set up to work great if the company progresses through normal, equity funding rounds. But that’s 1 in 10. (In 2020, maybe it was 2 in 10 – better, but not great.) For the other nine, something is going sideways or the company is going bankrupt. (By the way, sideways – zombies – are the worst case for investors: no return and no tax loss.) The SAFE makes no allowance for these (majority of) cases, generally leaving the investor with no recourse and no recovery. Those other cases – the majority of outcomes - is what those N pages in the equity (or convertible note) agreement cover.
When entrepreneurs pitch investors, they need to come at it with a sales mentality. They need to be cognizant that investors are looking not only at the business case… if you will make money… but also at the investment case… if they will make money. It’s a negative indicator if the CEO doesn’t get this, as it implies not only that the CEO will treat investor concerns as secondary, but also that they will have a similar lack of empathy when selling (unsuccessfully) to customers.
We'll discuss how to approach this in future posts.