This past Friday I drove up to Ft. Collins to check out the entrepreneurial scene in Northern Colorado. I did a quick tour of the Rocky Mountain Innosphere, which is a non-profit formed to accelerate the success of startups in the region. The Innosphere has hired new leadership and will be a meaningful resource to the entrepreneurs in the area. I plan to keep in touch.

The hidden gem of the trip was the tour of the CSU Engines Lab. Lab Co-Director Dr. Morgan DeFoot gave us a fascinating tour of the lab and showed us some of the intellectual property that was developed at the facility. More specifically, it was interesting to see how innovation in clean-tech differed from that in the software world.

Incremental Efficiencies vs. Market Disruption

As someone who invests primarily in software, I’m always looking for the product and team that is going to change the market. Market-changers are few and far between, and most of the time I get pitches focused on building a slightly different, yet better mouse trap: “Foursquare with automatic check-ins”, “Pinterest for pet lovers” or whatever other improvement you can think of. At High Country Venture we try and steer clear of software with incremental technology.

On the other hand, the CSU Engines Lab is all about creating efficiencies to the current infrastructure. A slight change in the efficiency of a disel engine can be worth billions in cost savings and have a significant environmental impact. Unlike software engineers who start from a blank slate these engineers are improving the current system. While this may not work in software, it’s a great model for clean-tech.

Why Does Incremental Innovation Work in Clean-Tech? 

It really comes down to distribution and switching cost.

• Most of natural gas is pumped using giant 2-stroke engines.
• Ninety four percent of two and three wheelers in India are powered by 2-stroke engines, each producing 6.5 times more harmful emissions that a 4-stroke would produce.
• Around 3 billion people use open fire to cook most of their meals, causing sever health conditions and pollution

2012 is said to be The Year of the Peer to Peer, and we are off to a great start. Every week I see a new peer-to-peer startup that is trying to capture the overcapacity in market via the “Airbnb business model” (also known as The Sharing Economy or Collaborative Consumption). This new breed of startups consists of everything from loaning money to purchasing imported candy. Why have these sites been created? Why now? And what are the attributes that make a good one?

Efficiency and social are at the heart of the sharing economy. If I have a fixed cost for something (empty office space or an empty seat in my car), I can receive incremental benefits by using the excess capacity. Since we are all socially connected on the marketplace, it’s much easier to find buyers for our offering. The peer-to-peer model is ingenious and works great for certain transactions, but is prohibitively difficult for others. Here is a list of the core components to launch a peer-to-peer marketplace.

• Third Party Product and Economies of Scale
• User Reputation
• User Acquisition: Both Supply and Demand Side
• User Experience
• Physical Hurdles to a Transaction

From a technical aspect, standing up a marketplace is as easy as ever. This is primarily due to the vast number of third party technology services that lower the barrier to entry. In addition to the infrastructure as a service companies (AWS, Softlayer etc), services like Legal Zoom and Stripe make it easy and affordable to have professional solutions without getting too deep into the details. In addition to the low startup cost, your marketplace will standardizing the transaction process, bringing economies of scale and the burden of startup costs down to pennies per transaction.

eBay, Craigslist and Amazon have paved the way with the consumer. People feel comfortable buying from strangers online, especially if there are some positive reviews or a reputation score. I realize that this crowd-sourced information is far from flawless, but I do believe that it solves the “Craiglist effect”, where every 2nd person is a scammer. If the marketplace owner adds some additional policing/guarantees in addition to the reputation score they will solve for the majority of the bad players.

Acquiring the critical mass of users is the hardest hurdle to overcome in the early stages. How does one ignite the supply side without any demand side and vice versa? How can one build a market that is dense enough to attract new users? Various tactics can be used depending on the offering, but it usually involves some type of viral game mechanic (credit for friends), geo-fencing (only available in Boulder/Denver) and/or seeding inventory.

Your success and the low technical barriers to entry will cause co-evolution in the space, aka. the rise of the copy-cats. These new entrants are trying to steal your market share and will create a lot of noise, confusing the consumer. Sure, you have the user today, but the new entrant is touting lower fees or some other incremental benefit. Basically, your offering has become commoditized, and it’s going to be hard to increasingly hard to differentiate. The best way to combat the copy-cats is through User Experience. This is the end-to-end customer experience. In the business model canvas it’s the customer relationship square. This is where most marketplaces fail because they don’t put in the hard work to understand the details of the transaction. Brian Chesky says it best in his interview, Airbnb.com: Necessity Begets Creativity:

I think that industrial design is all about user experience. You become a user, you become your own guinea pig, you learn to observe the world. It’s important that you put yourself in the shoes of the user and really use the product. I literally live in Airbnb.com…. Understanding nuances and learning how to empathize with our users. Also, improving the UX of site. As an industrial designer, you just have to consume it, you have to live it.

Since the marketplace is facilitating a peer-to-peer transaction, part of the customer experience is beyond your control. If a transaction in your marketplace has significant physical hurdles it’s going to difficult to succeed. An example of a physical hurdle is the transaction size: if an item is priced too low, it’s not worth the physical requirements (shipping cost, meet up, pickup etc.). Most of us have experienced a Craigslist sale where the buyer shows up 1hr late to buy a $10 item then he haggles you down to $8, or the hassle of packing and shipping a book on eBay for a whopping net gain of $3. Precise timing is another example of a physical hurdle that can hurt the user’s willingness to transact. In a ride-sharing marketplace people are very sensitive to the physical coordination required to fulfill the transaction, a 30min wait makes the ride share an inconvenient option.

When you get into to the details of the marketplace you begin to understand that excess capacity doesn’t always equal a market need. You can leverage third party services, seed the marketplace and be off and running in a few weeks. In the long run the difference maker is going to be the customer experience. It requires detailed planning and tight internal processes that enable your company to execute on the offering. The winning company will create raving fans. This involves thinking about everything from site design to the transaction process. It’s hard work and nearly impossible to replicate.

Before you launch your new a marketplace ask yourself if you want to build customer service company. Are you willing you willing to live it?

I meet with new startups everyday, it’s what I do. Every week I hear at least one pitch where the founder is trying to raise a large sum of money in the early stages of the startup process. The conversation usually sounds something like “we are skipping over the angel and seed round and raising a Series A of $3mm.” The amount of the raise is heavily correlated with the pre-money value of the company, which is correlated with the amount of risk in the business model. Early stage companies a have higher risk profile and a lower pre-money. A company in the early stages should seek to raise an amount that minimizes the dilution but allows the company to achieve the milestones necessary to raise a follow on round. A startup is a process and has a method that should be followed, skipping steps today will only increase the likelihood of future problems.

The purpose of this post is to go through run through lifecycle of a startup and correlate the capital raise with the stage of development. The secondary goal of this post is to use the Cynefin Framework to model each stage and illustrate the operations needed to achieve a scalable business.

The are are 4 quadrants/ontologies in the framework, Chaotic, Complex,  Complicated and Simple. To get up to speed on Cynefin watch this video or go to the Cognitive Edge. The framework has traditionally been used for Agile software development but over the past few months I’ve been using it to think about scalability.

BootStrap

This is purely the ideation stage. It’s where you and your 2 to 3 founders identify a problem or market opportunity. The problem begins in the Chaotic section of the Cynefin Framework. Your team will spend most of its time white-boarding a hypothetical solution to the problem. The first cut at solving the problem is usually pretty rough, (turbulent and unconnected) but you hack away, iterating on the approach, until some form of the product is manifested. This is a paper version which is articulated in wire frames mission statements, or a business model canvas. Since your entire team is working on the same project scalability isn’t an issue. 

Friends, Family and Fools

The product and the business model have been mapped out and you can articulate the vision. You start getting out there to see if your value proposition connects with customers. It does, and while your mom is not a valid test market, she still decides to invest. She gives you $20k to get you through the next couple of months. The majority of the problem is still in the Complex Quadrant with many unknowns and variables, but your team is able to distil the big idea into a minimum viable product (MVP). The MVP prototype allows you to test some assumptions with your target market, think clickable wireframes. This effort aims to reduce the number of variables by probing the market, sensing for input and responding with a different test. This phase is also known as the customer development cycle.

Your team has done several iterations and has nailed the prototype. It’s been a long haul but it’s now finally time to start laying the first lines of code. You and your co-founders spend the next month or more building out the MVP prototype. You finish and launch in private alpha and start collecting user data.

Angel Round 

Your initial code has served you well. Customers like aspects of your product but have uncovered some significant issues with the user interface. Thankfully the basic value proposition is solid. A few tweaks here and there and you think you can get the core product to market. You are ready for some Angel money and you raise $300k on a convertible note that converts into the Series Seed round. You work with an entrepreneurial law firm to roll the Friends and Family money into the note, which brings the total value to $320k. You and your team are still working out of the same room, but you find that using tools like Pivotal Tracker or Agile Zen are helpful to get everyone on the same page. Much of the problem is still complex but parts of it are moving to the complicated region.

Series Seed

Congratulations, the hard work you’ve done to date has paid off and you’ve launched your core product publicly. It’s officially for sale, you begin to test a small vertical in the market. Of course this product is only the tip of the iceberg, the grandiose vision isn’t built yet, but the data points you are receiving from the market are positive and you feel like you are on to something big. An early stage institutional investor also believes in what your company is doing and you raise $1mm. The $320k note converts into the round at a 20% discount. With interest the total dilutive capital is $1.39mm. You use the  $1mm of new money to hire a couple of developers, a sales/marketing guy and an undergrad to help with admin. The team of three has now doubled in size and you start relying on documentation to keep the internal team aligned and the investors informed.

While there are still chaotic, complex and complicated parts of your business, documentation allows you to simplify some of the basic tasks. This frees up your time to make the most important business decisions while keeping tabs on the operations. This is the first step in building a scalable machine. You begin the process by expanding the business model canvas into a List of Objectives. These are your value drivers, imperatives, branding etc.  The Objectives guide the Product Roadmap which conveys the value proposition to the end user and differentiates your product from the List of Competitors. The Key Performance Indicators tell you about your customer’s perceptions and allow you to adjust the Product Roadmap. The Financial Reports allow you to understand the economics of the business model and your capital requirements which ultimately affects your Organizational Structure.

Series A

You’ve moved your core product offering forward and your solution is compelling. Although you still have some additional features you want to add to the core product, it is pretty solid (the majority of the product risk has been mitigated). On the other hand your “real” product just launched and you still haven’t fully tested the market. The customers in your small vertical love the product but you haven’t marketed it to the full set of potential customers. Your Series Seed investors love the progress you’ve made and think the company is in a good position, and decide to follow pro rata in the Series A round of $3mm. You spend the bulk of it on user acquisition and marketing, hiring a full sales team. The team creates a Sales Funnel Model which reports deals closed, deals in the pipeline and the ROI on your marketing spend. You gain a few customers, do some analysis and realize that your initial distribution strategy was wrong and your pricing model was a little off.  You go through a few iterations and end up figuring out something that resonates with the large market you are trying to capture.

Series B and Beyond

You’ve got the product’s functionality down, the market is starting to pull and you simply need to add fuel to the fire. In order to keep up with the market demand and scale the larger team you’ve used structured documents to move your Chaotic, Complex and Complicated problems into the Simple Quadrant. You’ve succeeded in creating an organized scalable company. But this is only the beginning, you will require some growth capital to put your stake in the ground and own the market. Time for a bigger round of $5 to $20mm to improve the product and win the space.

Conclusion

1. During each stage of development you reduce then amount of risk in the business and thereby increase its value. As a founder you want to minimize the cost of money by raising an amount that is correlated to your risk profile. Raising a Series A round when your business has a Friends and Family type risk will alter the financing lifecycle and has the potential to complicate financing the business in the future.
2. Operating  an early stage business is much different than operating a mid or later stage business. As you grow leverage the use of documentation to move problems from the Chaotic/Complex Quadrant to the Simple Quadrant.