Identifying consumer brand potential through the ambiguity
Building and investing in start-ups is a game of extrapolation. Entrepreneurs and investors are tasked with forming theses on business opportunities using limited history and data. As more data becomes available with time, these extrapolations must be reassessed to evaluate whether the initial hypotheses remain true. This leads to an iterative process where the desire to pivot based on new insights must be balanced against the need to allow sufficient time to pass to prove a strategic initiative successful or not. To achieve this balance, decision making at management and investor levels must be rooted in the corporate strategy of the business and narrow in on the other leading indicators of success.
For this, I use a framework for evaluating consumer businesses that I wrote about?previously. This framework begins with five factors that I consider to be the leading indicators of a company approaching an inflection point as outlined in the diagram below:
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Management is paramount
Investors often speak of their desire to ‘invest in people first’ or ‘seek the best entrepreneurs possible’, which is intuitive as brilliant ideas can result in subpar business outcomes if the skills of management are mismatched to the needs of the business. But what do investors mean when they stress the importance of backing the best entrepreneurs? For some investors I’ve met, it means looking passed first-time founders, but I don’t believe that is necessary.?
Instead, I focus on evaluating the track record of success, the balance of business acumen and subject matter expertise, and critical soft skills, like determination, passion, trustworthiness and integrity.?
Experience building and exiting a business is invaluable for entrepreneurs who have it, but it’s not a requirement to demonstrate a track record of success. A compelling track record may not even relate to business pursuits alone. I consider a track record of success as a function of demonstrating an ability to:
When management can point to success across these activities, they are likely to receive a vote of confidence from investors.?
The second area of evaluation is the extent to which management’s collective skill set is balanced, especially related to business acumen and subject matter expertise. Too much of either can lead to suboptimal outcomes. A lack of business acumen being problematic for building a successful challenger brand is intuitive, but it may not be widely appreciated that business-savvy management cannot use their knowledge to overcome a lack of subject matter expertise in the consumer segment they operate in. Consumers today are quick to spot brands that are insincere and vote with their wallets when they do.?
Finally, in my book soft skills are as important as they are challenging to identify correctly. Determination, passion, trustworthiness and integrity are must-haves for management. Entrepreneurship is uncertain and fraught with numerous stressors that entrepreneurs must face. Therefore, management must have true passion for the pursuit at hand and be determined to push through the inevitable low points. This high-pressure environment necessitates trust and integrity or else the business with surely be unsuccessful – just look at the various cases in recent news.?
An investor’s evaluation of these soft skills begins at the first point of contact and often answers are formed subconsciously. Recovering from a poor start in this regard can be impossible, so entrepreneurs and investors alike must keep these attributes top of mind.??
Strategy drives everything
Strategy is an abstract concept and if you asked people what it?actually?means their answers would differ widely. This makes assessing the strategy of a consumer start-up challenging. In the hopes of making a strategy accessible, sometimes strategy is interpreted as a vision or mission statement. But that is not strategy – strategy is far more intricate. Instead, I think of strategy as written in?Playing to Win: How Strategy Really Works?(an excellent read for anyone interested in strategy – and one I highly recommend). The authors write that strategy is ‘a coordinated and integrated set of five choices: a winning aspiration, where to play, how to win, core capabilities and management systems’.
Put simply, this means:
Answering these questions in a coordinated way is complicated for a mature organisation, and even more so for a fast-growing challenger brand. If not already doing so, management should begin thinking of their strategy in this way while remembering that the process is inherently iterative. Those who do employ this approach to strategy will not only have an advantage when seeking partners, but also an advantage over any competitors who do not employ such an approach.?
Technology must be leveraged
When it comes to consumer brands, it is rare for technology alone to create value over the long term. If it could, Apple wouldn't invest the amount it does in its brand. But the role technology plays in a business now and in the future must be thoroughly considered to establish and maintain a competitive advantage and sticky value proposition.?
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Competitive advantage via technology can be fostered in many areas, even for products or services traditionally dependent on brick-and-mortar retail. Technology can create opportunities on the demand side (drive revenue) and/or it can create operational efficiencies (drive profitability). Effective start-ups identify where these opportunities lie and seize them quickly.
A good example of this is Spotify. Always existing at the intersection of technology and media, in its early days Spotify seized the opportunity to generate a competitive advantage through its technology. However, as competition increased the technology gap was closed. Today technology remains an important component of competitive advantage, but a supporting one I would argue.?
Instead, I see Spotify’s right to stream a volume of content that is broad, desired by consumers, and increasingly exclusive to their platform as their primary competitive advantage. I say this because content drives Spotify’s business model and has done for years now. Over 85% of Spotify’s turnover is generated from premium subscribers and, according to management, most premium subscribers are converted from free users.
In a competitive market, Spotify uses exclusive content to drive growth in free users who are converted to premium service as the value of Spotify’s content is proven with time. Premium subscribers are then retained through Spotify’s proprietary technology, which provides an enhanced user experience through highly effective content prediction algorithms, among other benefits. Said another way, in the past technology presented a demand opportunity for Spotify, whereas today the demand opportunity comes from content while technology provides increased operational efficiency.?
This example also reinforces the need to reassess the role technology can play in competitiveness as the company and its market evolve. The bottom line is by overlooking how technology can increase a company’s competitiveness an entrepreneur is taking the risk of another competitor supplanting them.?
Market size is nuanced?
Market size, or?TAM?as VCs like to call it, is often a key marketing metric for start-ups; however, it alone provides little insight into the quality of an opportunity. Instead, investors like to know TAM because it offers a glimpse of the revenue-generating potential of the business at maturity and gives insight into how well management knows their business’s place in the market. Therefore, when it comes to market size there is often a discrepancy between what entrepreneurs think investors care about and what investors?actually?care about.?
First, when it comes to the revenue-generating potential, bigger isn’t always better – it’s just?bigger.?Yes, the size and value of a company are highly correlated, but higher enterprise value on exit does not equate to stronger return on investment. Instead, investors search for the ‘right’ market size for them based on external factors (e.g., competition, average price per unit, frequency of purchase) and internal factors (e.g., assets under management, and team size). An attractive market size to one investor may be entirely disinteresting to another investor.?
Personally, my view on market size goes like this: the right market size is one that can reasonably allow a company to gain the scale necessary to create value sufficient to meet the expectations of an entrepreneur and their investors. With no other constraints, my inclination is always to partner with entrepreneurs who can articulate the size of their market opportunity and demonstrate that they understand the part their company plays in the broader market.?
For entrepreneurs I think the latter part is key. Having clear line of sight on the addressable market and its size goes a long way in showing an investor the extent to which you understand your business and its strategy. Focusing on the absolute size of the market instead of a company’s place in its market is a trap that can lead entrepreneurs to fall short of their expectations when seeking partners.?
Timing matters with consumer adoption
Consumer investors will always seek evidence of consumer adoption before investing. The key to remember is that the definition of consumer adoption changes as a company advances through its lifecycle. For a pre-seed investor, evidence of adoption could be based on the success of a comparable business in a tangential market or different geography. Later-stage investors, on the other hand, will seek clear evidence of adoption in the markets and channels a prospective company operates in to identify future market-leading potential.?
These differing views on what consumer adoption means relate directly back to the risk-return expectations of investors at different stages.?Early investors have the opportunity for the greatest returns because they take on the greatest execution risk, but this can manifest itself as inefficient capital deployment if product-market fit has not been achieved quickly. Execution risk remains beyond the point of clear consumer adoption, but it’s comparatively less pronounced, which is why later-stage investors have lower expectations for returns relative to shareholders who came before.?
Inefficient capital deployment is not just problematic for investors. The high cost of venture capital means it is best suited for companies capable of creating significant value during the runway provided by an investment. Value creation will never be linear but, if venture capital is invested inefficiently by a company, the shareholders of that company can reasonably expect to suffer higher dilution than initially expected. Since entrepreneurs are often not the ones investing the capital, it means they face the greatest risk of increased dilution.?
In the context of today’s market for consumer brands, entrepreneurs need to demonstrate compelling evidence of consumer adoption before taking on venture partners.?
Businesses can never stand still?
No company will have the perfect combination of all the qualities detailed above, but winning businesses will score well in several areas, and where they don’t score well, they will have clear plans on how to improve. Entrepreneurs must remember that each component doesn’t need to be benchmark beating either; consistent strength across the five areas can create a potent combination for growth.?
Further, a repeated pattern above is that none of these components is set-and-forget. A winning combination of management, strategy, technology, market size and consumer adoption can over time become a losing one if critical reassessments are not performed periodically. Only through reassessment can entrepreneurs test whether the extrapolations made to date hold true. This never-ending puzzle shines a light on what makes start-ups?ambiguous. Incomplete fact sets lead to interpretations that vary from person to person, sometimes considerably. To be successful entrepreneurs must search for ways to find direction through this ambiguity, and this is exactly where a structured approach to analysis can beneficial.?
Lucas is a consumer investor in London and previously invested in consumer start-ups across Canada and the United States. At District Ventures Capital ?he played a part in more than three-quarters of the investments made from inception through 2022, over half of which he was accountable for as the deal lead for the team. He is passionate about learning new businesses and helping them reach their goals, regardless of the stage. To get in touch, find him on?LinkedIn.?