By Avery Faller
Speaker: James Geshwiler
Company: CommonAngels
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.
The Takeaway
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
Investors often weigh the strengths and weaknesses of a venture’s founding team as much as, if not more than, the strengths and weaknesses of the venture’s product. It is important for the investor to feel confident that you, as the founder of a company, will be able to build your product either through your own great knowledge or through your ability as a leader to attract talent to join your team. During his talk to the YEI Fellows last week, the founder of Pico Quantitative Trading and sometime angel investor Jarrod Yuster explained what skills investors look for in a good founder.
At startups, people are called upon to widen their roles to fit the needs of the growing company. One of Jarrod’s main points about founders is that their roles will change as the company grows and its needs evolve, so the traditional, specialized employee can actually be at a disadvantage in a startup. When investors are examining a founding team, resourcefulness and flexibility are important because these skills will allow the founding team to adapt to changing situations as their company grows and morphs. 
OK, so your company is doing pretty well. You’ve built out a beta of your product, you’ve received some positive user feedback, you’ve identified your primary market, and you have an experienced team with complementary skills. Now what? Well, it sounds like your company is in a good position to begin seeking funding. Last week, Mary Anne Rooke, a member of Connecticut’s Angel Investor Forum, came to speak to the YEI Fellows about the funding process. Mary Anne explained the differences between the different types of funding and who invests in each stage. If product development is in progress you should seek Seed Stage funding, which will primarily come from Founders, Friends and Family. If your company is beginning to make sales, then you should seek Early Stage funding from Angels and Boutique VCs. And if your company is beginning to ramp up sales and needs a hefty dose of capital to do so, then you should seek Series A or B funding from VC firms. 
So, when exactly is it time to seek funding? According to Mary Anne, it’s when your company has made as much progress as possible with the resources it has on hand and can literally go no further without funding. If your company is looking for a raise between $250,000 and $2 million dollars, then you’re most likely looking to Angel Investors—last year, although Angels and VC firms each invested around $17 billion nationwide, that money was spread out in 57,000 deals for the Angels, and only 2,800 deals for the VC firms. That means that although funding is really, really hard to receive across the board, it is much more likely to receive an investment from an Angel over a VC firm. 
David S. Rose has seen it all. As a lifelong entrepreneur he has ridden the wave of the technological age through booms and busts, bubbles and the birth of entire new sectors. Yesterday, David spoke to the YEI Fellows about the venture capital funding process; in particular how to represent yourself and your company when presenting to investors. His unique experiences on both sides of the table as a serial entrepreneur and as an angel investor showed through as he gave an insightful talk about how to pitch. 
