Picking an Idea

If you’re a founder who wants to raise capital from a U.S. VC and you haven’t settled on an idea, this post might help.

You must consider any emotional factors that apply to you separately, this article won’t discuss them.

What VCs Care About

VCs exist for big, expensive bets that can generate huge revenue or huge acquisitions. If you don’t need their money to scale or your upside isn’t large enough, there’s no point doing VC.

VCs will invest if their investment committee believes:

• With a small but non-zero probability, your company’s valuation will exceed $1B;
• Your business is far more likely to succeed if it’s well funded;
• Funding your business won’t interfere with their other investments or damage their reputation.

They’ll be extra eager to invest when they expect your next funding round to come at a significantly higher valuation, as this boosts the value of their stake in your company (at least, on paper) and offers them an early opportunity to cash out their stake.

The Checklist For Getting Funded

VCs are run by busy, often tired, humans. They won’t research your idea, they’ll know only what you tell them.

You should choose an idea that makes it easier for VCs to see how they’ll get their return.

VCs don’t have time to overthink each business idea. They depend on rules-of-thumb to judge businesses; it’s fitting describe their decision-making technique as a “commercial instinct.”

There are two types of commercial instinct: sensing and intuiting.

Sensing VCs look for traction, revenue, and public hype. They rely on what’s already happening to judge future success. To founders, this looks wildly speculative: the VC anticipates future success from a short, possibly misleading, track record.

Intuiting VCs look for strategy, novelty, and density of talent. They rely on the company’s narrative to judge future success. To founders, this looks methodical: the VC is doing deep analysis and asking all the right questions.

Every VC has both instincts, but often favor their sensing instincts. Sensing doesn’t require them to predict the future.

Appeal to both instincts for the best terms.
Appeal to at least one to get funded.

Sense-based Criteria

• Evidence that the business has experienced growth in its user base;
• Evidence that the business has won over credible outsiders;
• Evidence that the business has won mindshare;
  • Your business’s brand is widely associated with the issue that your business solves.
  • There are no other brands widely associated with the issue that your business solves.
• Evidence that the founder is good at making money.

You can satisfy these criteria without founder-market fit, product-market fit or revenue.

Intuitive Criteria

• Reason to believe that the business could shift its focus toward much larger revenue-generating opportunities without significant restructuring, a change of brand, or a change of personnel;
  • Explanation: VCs know that they can’t accurately predict whether the current plan for the business would lead to future success, so they ask themselves, “Would it be rational to bet that the business could achieve profitability, based on what I know about the founder and their north star, if they didn’t have any short-term plans at all?”
  • I’m highlighting the degree of fit between the founder and their north star, whether the north star has enough breadth to cover multiple possible products, and whether that north star is believable. I’m not trying to highlight overall founder competence.
  • VCs will consider whether the business is operating in a booming market, if the business has positioned itself uniquely relative to other firms, whether the core thesis of the business is flexible enough that they could redefine themselves, whether it would be rational to bet on the team’s ability to create profitable products if the current plan did not exist, etc.
• Reason to believe that the founders are better equipped to make decisions for this business than anyone else, for tangible reasons; i.e., they know something that is crucial for the business to succeed while other people don’t, and they have an abundance of topic-relevant experience, etc.
  • Explanation: If not, why hasn’t somebody done this business already? Even if the VC believes that the business idea is an unexploited arbitrage, they should be able to explain why the founders were able to identify this idea earlier than others. If such an explanation exists, the founder has already demonstrated their superior capacity for decision making. Ideally, the founder has chosen their strategy carefully, on the basis of experience that other people don’t have, and this should benefit the business over a long stretch.

You could satisfy these criteria without traction.

The Most Overlooked Factor

This is the intuitive criterion that both VCs and founders often overlook.

• Reason to believe that the business’s ability to remain competitive will compound, i.e., the progress the business makes each month will enable it to execute on more significant opportunities in the next period, and (ideally) every achievement continues to pay off indefinitely;
  • Explanation: VCs expect the business to create more revenue if they can: 1) develop a monopoly over their product segment, and 2) expand the range of products and services they offer without losing focus. I’ve mentioned this idea of a “compounding edge”, as it is the variable that drives both monopoly power and horizontal expansion. VCs must ask themselves “does the business idea, and the market the business will operate in, make it easier for the founder to gain and maintain monopoly power?”
  • Ideally, every customer relationship, hard-won employee, customer insight, technical development, long-term contact, etc, should meaningfully enhance the company’s ability to succeed, even as the business switches its focus onto bigger opportunities with different requirements.

The traditional advice suggests that compounding competitive advantages only matter later in a business’s life. I disagree: if both the VC and founder anticipate that the business will hit a ceiling, the founder risks losing motivation or hitting barriers earlier than expected.

Epilogue

I’ve opted not to mention idea-specific factors. Many VCs ask founders to propose a concrete business plan and demonstrate traction, but this is usually performative. VCs will offer tens of millions to startups that are pre-product, if they have intuitive reasons to think their valuation will multiply.

Optional Advantages

You must embody at least two of these, otherwise you’ll struggle to raise.

• Evidence of revenue-generating activities within the company;
• Evidence that the founder has created significant revenue before;
• Evidence that the founder has positive relationships with other VCs;
• Evidence that the founder can capture public attention;
• Evidence that the founder has rare access to business-relevant resources;
  • access to good potential hires, technical knowledge, relationships, etc.
• Evidence that the business is sought-after by other VCs.

What Founders Care About

You must choose your idea to appeal to VCs’ commercial instincts. Each VC’s portfolio and decision-making style reveal what will and won’t resonate with them. They all heavily depend on similar rules-of-thumb when making investment decisions, regardless of what they might claim. You should take their reputation with a grain of salt, also. If you understand each VC’s style, you can identify investors who’ll offer better terms and tailor your pitch to them.

You could also ignore every piece of advice that a startup incubator (i.e. EF, YC, etc) offers yet still receive their investment. Mature VCs know there are many ways to build a profitable company; there are many different ways to appeal to the same group of investors, you must pick one.

Side Note: If you raise from the right VC, you’ll find it easier to raise in future. When your current investor has a strong reputation with your next one, their endorsement reflects positively on your business. It’s also possible to hurt your chances: VCs often display tribalism, and raising from the wrong investor can discourage certain other VCs from investing in future. VCs’ incentive to promote their portfolio companies and their fear of missing opportunities can lead to irrational crowd behavior, i.e. financial bubbles.

You must also choose your idea to optimize for revenue.

The lifecycle of your business will look something like this:

• Discovery Vehicle: doesn’t yet provide a good or service, still learning about the market;
• Startup: minimal revenue and minimal resources, yet provides a good or service;
• Early Firm: some revenue and significant growth-critical resources;
• Mature Firm: has mostly expended its growth-critical resources and generates revenue;

If your business can’t survive the transition between each stage, it will never achieve its revenue potential.

You’ll need a strong strategy, unique positioning, and many resources to become a mature firm. You’re unlikely to develop an appropriate long-term strategy during the discovery stage. This is fine, if you have a good reason to believe that you could form a better strategy later.

When judging an idea, ask yourself: “will this lead me to a dead-end?”

The Core Factors

• It’s very likely that businesses in your market will generate substantial revenue if your core beliefs are true;
  • Founders, being rational, know that they’ll probably need to pivot. If your immediate plans fail, forcing a pivot, it would be better for you if you didn’t need to leave the market to do so, as you could retain some of your progress and most of your insight into the customer. Thus, it’s important for you to believe that a massive company will exist in your market, regardless of whether the first product you considered selling is worth making.
• Your core beliefs, which inform how you act in the market, are contrarian;
  • It is better for you if your competition is prone to making predictable mistakes, even if they have knowledge of the product and have enough resources to compete. It’s possible for you to guarantee this by selecting an idea that would fail if the obvious strategy were followed, and opt for a controversial strategy that you’re confident will work.
• Other founders, with similar strategy and resources, haven’t failed within your target market;
  • It’s better to learn from the mistakes of others, it will help you avoid areas where you’re unlikely to make revenue.
• You have a clear plan of action, driven by short-term KPIs that are directly relevant to your long-run plan;
  • If an immediate plan of action can’t be formed, there’s no point.
• EITHER Other founders don’t have the knowledge, expertise, or resources needed to identify and then achieve the core premise, whereas you do OR Other founders will fail if they attempt a similar business at a later time, if you capture the market early OR Other founders are biased against starting such a business for personal reasons (it’s boring) or social reasons (it’s controversial), whereas you aren’t;
• EITHER There isn’t a Schelling point (popular meeting point for relevant technical talent or business-relevant community) for the core theme of your business OR it’s viable to publicly counter-position relative to the entity that already has the attention of potential customers and potential hires;
  • It is better for you to have access to difficult-to-find talent and recent insight, otherwise it would be too easy for a potential competitor to mimic your strategy or compromise your social-technological moat.
• If you continue to participate in the industry where you started your company, you would enjoy an increasing rate of return on your time over at least five years, in terms of: your own industry-relevant professional experience, your ability to hire within the industry, and the industry-relevant value of your social network.
  • It might take ten years to exit a startup, possibly longer. It would be ideal for you if you enjoyed increasing rewards over time for continuing to specialize in your chosen industry; otherwise, you might feel that your ambition has regressed or that your potential to earn has reached its limit.

The Factors That Help You Raise

These should help you maximize the sense-based appeal of your idea.

• Your business will do things that attract public excitement in the short term.
• You can, in the short term, take actions that will make the company look more likely to generate revenue, from the perspective of a VC.
  • VCs don’t buy into existing traction; they buy into future traction.
  • VCs like existing traction because it makes promises of future traction credible.
  • There are other kinds of actions that can foster confidence in the revenue potential of a company, such as public technical achievement and credible third-party validation.

Selecting for Traction Potential

It’s clear that some founders don’t need traction to raise a large round, yet most do.

If a founder has achieved traction, their claims will sound more believable.

The Hope: “Person X has Problem Y; I’ll sell Solution Z that solves Y to X.”

When you break this statement down, you’ll realize that finding a great idea is significantly harder than it initially appears.

The Break-down

You can use this to test your ideas.

You should try to defeat your ideas point-by-point: if it’s easy to defeat, it’s not worth defending.

1. Person X has Problem Y.
   • Y conflicts with X’s most significant motivations, rather than their secondary priorities.
     • For B2B: X will be promoted, avoid being fired, or mitigate personal disaster if they address Y; it would be impractical for X to keep their job without adopting a solution to Y, if such a solution existed.
     • For B2C: it’s hard to say; you must judge based on X’s willingness to pay for a solution; if X can’t readily quantify how much they’re willing to pay for a solution, the problem doesn’t present a significant threat to X’s core needs.
   • X’s return on time for identifying and purchasing the solution to Y justifies their effort, i.e., they’re not preoccupied with higher-priority problems.
   • X can adequately assess the severity of Y; X displays a rational attitude toward Y.
   • Assuming that X has made every attempt to fix Y themselves, including attempts to create a partial solution, the issue is still as urgent as it looked initially and all of these statements remain true.
2. Product Z can fix Y.
   • If X were to buy Z, it would eliminate the practical and emotional consequences of the problem, without leaving behind any concerns that X couldn’t adequately address.
   • X could clear barriers to Z’s adoption, enlisting external support if necessary.
   • X will choose to clear any barriers to Z’s adoption, of their own volition, if offered Z.
3. I can sell Solution Z to X.
   • X will trust me.
   • I’m willing to sell Z at a price that X can afford.
   • EITHER X can pay me OR X can force a surrogate (i.e., their boss) to pay me.
   • I can create and distribute Z.
   • I can identify, contact, and engage with X.
   • X won’t prefer a different solution.
   • X won’t prefer a different seller.