The 363 test for new ventures

When we work with entrepreneurs to build a new business venture, we often get their agreement to take the “363 test”. Simply, at the end of 36 months of starting the venture, we must be able to answer “yes” to at least one of the following 3 questions:

1. Are we in a position to sell the venture?
2. Can we float the venture in the stock exchange (aka IPO)?
3. How do we close and wind-up the venture?

There should be nothing in between as anything else will mean dragging our feet for another potentially long period of our lives, only to see that the venture could end up in the same place as Number 3 much further down the road, and our mortal lives are too short for that. If we are unsure of the answers to any of these questions by the 36th month, we can at most give ourselves another 12 months (a “+12” allowance) but by the 48th month, we must make one of these three decisions.

Two critical outcomes to look for and one to avoid in running a business

I have learned from experience and have had the benefit of hearing from a very successful entrepreneur who once told me that

“the worst type of business to run is one that makes too little to succeed, and loses too little to fail.”

He meant that when one of the following two outcomes happen to our business, it is good news:

• Outcome One: our company makes so much money that we can sell it or continue to grow it (of course we all know this, although a clearer analysis is needed on help us determine what is meant by “make so much money”, but that’s for another discussion);

• Outcome Two: our company has lost and is continuing to lose so much money that it makes more sense to close it before it’s too late.

According to him, these two states would help the entrepreneur decide clearly on what to do next.

It is the third state of not failing enough and not making enough that traps many entrepreneurs. It places us in a zombie state of entrepreneurship, too healthy to die, yet too sick to live.

This wisdom makes a lot of sense when we hear it, but takes a huge toll on the entrepreneur to act on it, simply because it has taken all of our dreams and waking moments nurturing this enterprise, this baby of ours till this stage, and now we need to end it??? It is a tough call. Yet, those wise enough to know this truth at the outset will humbly and actively plan for what it takes to push the enterprise to not only avoid closure but flourish towards new heights, and the timeline of 36 months is just about right for a company to reach that kind of state.

Of course, many entrepreneurs before us have grown successful businesses on pivots from their original offerings while some have persevered to success. I can think of Rovio (the creators of the Angry Birds franchise) and Pinterest to name two. As entrepreneurs, we celebrate our ability to persevere, to demonstrate grit, determination and passion to get the job done when the going gets tough. Nothing of what I have written here changes or diminishes any of these qualities. We must have them if we ever wish to change the world. But having the right mindset at the outset is vital if we want to do so in a productive and pragmatic way. And preparing ourselves to face these three questions at the end of a limited period will help us frame our thinking with an end in mind. At least if we need to face the inevitable by then, we are prepared for it.

True entrepreneurs do not stop seeking to solve problems in the world we live in. And one business closure shouldn’t stop us from starting another soon after.

Yet, it is not to say that we have to sell the enterprise or float it in the stock market if our venture is so successful by then. But having this goal at the outset means we better plan for it, and having the option to do so then means we would be in a better position to grow it further, although I would advocate sticking to one of those two “exit” questions would make good business sense.

Three steps to plan for Outcomes 1 & 2 at the outset

Here are three steps to consider when developing the growth plan for our enterprise. I would argue that this should be done before any fund raising activity as it is a lot harder to convince investors without demonstrating that we have what it takes to grow the money they invest in our enterprise over a foreseeable future:

Step One: Determine, right from the start, the fiscal goals we want achieve for our enterprise at the end of the 36-month period.

John P. Kotter, in his book Leading Change (1996), characterises

an effective vision of success that move people to go for change to comprise the following attributes: imaginable, desirable, feasible or attainable, focused, flexible, and communicable.

Concrete goals that are measurable give clarity to vision, and enable stakeholders to track progress, steer the enterprise, manage resources, and pivot the strategy where needed. Fiscal elements provide the data points we need to model up to these concrete goals that form the integral part of the vision for any new venture.

Here are some questions can help us frame our financial or fiscal goals for a new venture:

• What is the realistic market opportunity we can capture, based on the number of customers, and the price we can charge per customer in a year?
• What valuation of our enterprise do we hope to attain at the end of 36 months of incorporation?
• What sort of measurable targets we need to set for the number of customers we need to bring on board by the end of 3, 6, 12, 18 and 24 months in order for us to be able to justify the valuation we hope to attain in 36 months?
• What evidence in the current market conditions suggests that we can ask for this valuation of our enterprise, based on the financial metrics we can attain during this period?

It is crucial that we do not simply plug in numbers from nowhere but we need to do a fair bit of research to see if what we have stated here is valid or at least reasonable. For example, in determining the Total Addressable Market (TAM), it is often tempting to over generalise the market we intend to operate in when our offering may only be attractive to only a small subset of that market. As a result, the market sizing number can be so large that any derivation of market opportunity downstream will appear unrealistic. Let's use a hypothetical example of a mechanic that services Honda cars. Say Honda sold 5 million cars worldwide in a year. The total addressable market could be said to be 5 million cars. But if the entrepreneur has used the number of total cars sold in a year, regardless of brand (which works out to be 66 million cars), to suggest a total addressable market, the opportunity is inflated so much that any further derivation of Serviceable Obtainable Market (SOM) would seem unrealistic.

Step Two: Work backwards to model the business.

Once we have more or less set the target valuation for our enterprise, we can work towards building up the business framework that comprises customers, partners, costs, expenses. Modelling a business is crucial to helping the team and investors see how we can achieve what we set as targets over a foreseeable period of time. The form that such models may take could be a slide deck that explains how we make money, from who, and if we could make a profit by when. It needs to be supported by a spreadsheet document that details such elements as forecasted Profit & Loss, Balance Sheet, Cash Flow Statements.

We need to consider several elements here. For example, in considering how we will derive revenue and profit for our new venture, we should think about:

• The unit economics: how much is a reasonable charge to our customers, how do we know that they will buy at this price? What are the precedents on similar products and services?
• The time-to-market: when do we expect to start selling and how many customers do we expect monthly during the course of the next 24 months?
• The acquisition engine: do we differentiate between users and customers? Do we have a funnelling system or acquisition engine that helps us find and get paying customers? What is the conversion rate?
• The cost of doing business: how much would it cost to acquire a customer and to service each deal? What is the expected gross profit margin for different types of services or products? What other expenses do we need to consider on a monthly basis?

If we are honest in modeling our business, we could use the data from this exercise to see if our valuation expectations in Step One have been unrealistic, then go back to adjust our expectations and goals. Do this a few times and we should get to a point where we can pitch to potential investors with some level of confidence.

Step Three: Determine and find the resources needed to realise these goals.

Pragmatically, we need to ask ourselves:

what is the lowest possible amount of money we need to get the business off the ground to the point of generating revenue of up to $200,000 in three months?

This is a crucial consideration as any form of fund raising can take anything from 3 months (with angel investors) to 6 or even 9 months for institutional investors such as VCs and Family Offices. These days, investors will need to look for evidence of early traction in the form of revenue generated (no longer just user count) to suggest that people are keen to reach for their wallets to buy our product or service, even if these customers are doing this only to try out the experience with our company. Thus, any attempt by founders to bootstrap their venture in the starting days will demonstrate to potential investors that they are serious about their business idea.

In my experience, any venture that seeks a third party (not friends or family members) to support it financially will need to demonstrate at least one of the following elements by the time it goes to the market to look for funds:

• Revenue, which suggests that the service / product has a tangible value that people would pay for and has paid for it. This is the best form of assurance to an investor in the early stages of a venture as any business idea remains an idea and a business vision remains no more than an image until someone actually pays for it. However, if revenue is not possible at this stage (ie. pre-revenue stage of the venture), we can consider

• Proof of Revenue. Simply put, this is a pipeline of projects, customers or buyers for the product or services that you will be delivering in due time. It typically should be supported by some form of documentation (a signed agreement or a pre-sale order is best) that shows that the unit economics we have modelled in Step Two is legit. This further lends credibility to our model and asking valuation.

So how do we bootstrap our way to the stage of acquiring revenue of at least $200,000 in three months when we, the founders, are all too poor to buy new stuff, hire new people to even start? One way is to find together a team of people who are likeminded and passionate enough to join us as co-founders and are agreeable to work either on a success basis or for no wage until revenue is generated. You may be pleasantly surprised that many qualified individuals or even companies do exist and can help you reach those targets at little to no cost upfront. You just need to go out and look and be open to share a bit of your enterprise with them for the sacrifice they make to advance your vision.

Know your numbers

One of the most brilliant investors I know personally once related to me his observation of an aspect that highly successful entrepreneurs, who grew their companies from a valuation of $1m to $10m, from $10m - $100m, and from $100m to $1b, had in common --- they were either personally savvy or had someone who was savvy with finance to help them. He reckoned that this often is a make-or-break formula for a growing enterprise. He is not alone in this observation. In one of the rounds of fund raising I did for my previous venture, one of our investors, a NYSE-listed company had only one condition when they invested in us: to 'take back' the management of accounts and finances instead of outsourcing it to a third party.

This is no simple task for the entrepreneur, who already has the burden of charting a compelling vision for all stakeholders to believe that she can change the world with her business idea, and the responsibility of motivating the troops on the ground to fight till the death to make this vision a reality. She also needs to ensure that all her customers remain happy and stick around to buy more, subscribe further, and to spread the word to others. Already a jack of all trades, now she needs to double up as the CFO?

One way to get around this is to partner other players or to seek collaboration with people who can help us make sense of the fiscal performance of our enterprise and most importantly, help us derive its value based on what we have or need to achieve in terms of unit and financial metrics. Enterprise valuation is a tricky thing and quite a different craft from what entrepreneurs are familiar with. But it is an essential aspect of running a growth-oriented venture that seeks to meet Outcomes 1 and 2 after 36 months.

Plan and navigate with clarity

Most new ventures fail within 24 months of inception. With clarity of thought, target and thrust, we can mitigate this outcome. The 363 test for new ventures helps entrepreneurs ground their business ideation process and establishes a framework for building a business towards a vision of success that is imaginable, focused, concrete, and compelling for all parties involved.

I am a venture builder. My colleagues and I boost the value of enterprises that are led by champions with a relentless determination for real growth and an open mind for things done differently.

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Reference: Kotter, J.P. (1996) Leading Change. Harvard Business School Press, Boston.