By Avery Faller
Speaker: James Geshwiler
In his talk to the YEI Fellows James Geshwiler spoke about a variety of issues from the inner workings of an angel investor fund to why President Obama wants more entrepreneurs. Perhaps the most interesting topic that James touched upon was that of areas of potential risk and return in a startup, which investors (like James) use to evaluate your company from your pitch through due diligence.
While doing due diligence on a large number of companies, James uses a classification system that he learned while he was an analyst for the CIA. Originally used as a tool to help think about potential Soviet espionage and state secrets, this system is comprised of three categories: Secrets, Mysteries, and Imponderables. Placing information into one of these categories allows the evaluator to recognize which pieces of information are attainable and which are not, saving time and increasing accuracy.
Due Diligence with a Grain of Salt (or Two)
Secrets are pieces of information that are not immediately apparent, but do actually exist. Investors like to see startups that have exclusive rights to proprietary information, like patents and algorithms—in other words, “secrets.” These give the company a distinct advantage over potential competitors. For example, the hypothetical company Nacho Cheese X, which manufactures and sells nacho cheese, keeps its proprietary cheese formula a secret. However, secrets aren’t always positive: despite their secret recipe, Nacho Cheese X lost $300,000 last year. And there are secrets about the competitive landscape and other players, like what Nacho Cheese X’s biggest competitor Macho Cheese’s next product will be. A major component of due diligence is unearthing the secrets about your company and evaluating your competitors as well to ensure that you are truly differentiated and that your product is competitive in the market.
Mysteries are things where there is an answer, but there is not a direct way to discover it. For example, the question of “What is the size of the nacho cheese market in the US?” is a mystery. Some analyst companies may perform detailed analysis and come up with a number for the market size, but in many ways this is still just a rough estimate. The risk associated with mysteries can be mitigated by employing work-arounds like this to guess at what the true answer will be, and smart investors include this type of analysis in their diligence.
Finally, Imponderables are things that there is no way to know or figure out. “Which company will dominate the nacho cheese industry in 5 years?” Nacho Cheese X will work hard to increase its market share, but there is simply no way to know for certain if they will “win.” This is especially true in technology industries where product turnover is incredibly high. For example, the first iPhone was only released a little over 4 years ago. One way to deal with imponderables is to try to be prepared for any potential situation. Nacho Cheese X, for example, also plans to release Salsa and Hummus lines to diversify its holdings. As an investor evaluates an opportunity, this is where the true element of gambling and risk comes in: in a way, he or she must make a leap of faith hoping that the imponderables remain favorable for your company.
Just as investors use this framework in assessing investments, it is also valuable for entrepreneurs when evaluating an opportunity or defining a strategy for their fledgling startup. Consider what information you need to know to be successful, and place it into each bucket – secrets are discrete facts you can find out, if only you look in the right place or ask the right person, so ask! You can make educated guesses about mysteries, drawing inferences from various sources or estimating based on other knowledge. Finally, accept that imponderables are just that: unknowable pieces of information that any amount of thinking and research will not be able to reveal; obsessing about them won’t work, but you can turn your energy toward hedging your bets. In other words, don’t ask “Will I be successful?” – focus instead on doing what you need to do today that can turn that imponderable into “just” a mystery (or a secret!).Read More