LatAm StartUp Challenges: Why startups should raise capital today, not tomorrow

Takeaway: Bootstrapping or Raising capital is an easy decision if you can answer a far more difficult one: Are you building a startup with solid barriers to entry?

As an entrepreneur in Latin America one of the hardest decisions is whether to bootstrap or to seek outside capital. While these decisions are very case specific, our firm’s view is that you should definitely decide to raise outside capital if your business venture is one where you can build significant barriers to entry. There are many forms of barriers to entry, but advanced technology stacks, network effects, economies of scale or scope, and improved business processes are all integral to creating solid barriers to entry.

In a traditional businesses,  there can be few of the above mentioned barriers, and the main defense against competition becomes a strong brand. A brand can be a very powerful barrier to entry (see: Coca Cola), but a strong brand is the result of careful and controlled growth. Startups, by their definition, are not intended to execute slow and controlled growth but, on the contrary, fast growth. Good startups need to execute fast growth because they are solving a pressing problem, one that requires an urgent solution. Startups are not conceived to build a brand over many decades – though some will, and will therefore add brand to their barriers to entry.

In a competitive market, where a pressing problem exists, there are likely to be many more than one competitor trying to solve a problem. Most startups will seek to solve a problem in a manner that leverages trechnology to create barriers to entry to other participants. That is, the succesful startup is likely to start creating barriers to entry as they grow with the objective of setting up a “powerful business moat” (barriers to entry). In doing so, they will likely increase the costs to compete and scale for other startups that intend to solve the same problem.

One of the old adages in Silicon Valley is: “Optimize for the pie size, not the slice”. That thinking applies best to businesses that will be able to create and capture significant value in a form that beat incumbents and other startups if properly executed. If your startup has limited barriers to entry, like a restaurant, the founder should be thinking about maximizing the pie slice. If you are building the next Facebook, with solid network and technology barriers to entry, you should think about maximizing the pie size, as any slice will be awesome.

In this context, the answer to the question of “Bootstrap or Raise capital?” is obvious. The truly difficult question the entrepreneur needs to ask is whether or not the startup will be able to build powerful barriers to entry and create significant long term value. If your startup will create barriers to entry, be the first to start setting them up because the value creation you will accrue will far outweigh additional potential dilution. Even if operating profitably, the entrepreneur that raises capital will be able to accelerate the creation of barriers to entry,  reduce the chance competition will be succesful, and capture a larger share of the opportunity value. Once the decision is to raise capital, the faster you can raise the capital the better. Setting an unrealistic valuation upfront and hoping to grow into it, or eventually find the investors that will pay the appropriate premium is effectively giving your competitors the opportunity to catch up to you and you risk letting them build barriers to entry against you. That is, you may loose 100% of the value of your startup to avoid giving up an extra 3-5% of your Startup. 

This appears self-serving advice, after all I am in the business of funding startups at the lowest reasonable value and expecting an exit at the highest possible value to make my LPs happy, but it is not. Escala.VC couldn’t possibly fund all the great companies that are or will be in Latin America, the market will determine the right valuation levels for each fund raising round. However, we have seen too many startups that lost momentum and competitive advantages while sitting around waiting to complete fund raising rounds at valuations far above market.

Think about what you want to optimize for.

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Validate your product with _customers_ asap

Takeaway: Don’t be afraid to try your products with your customers before they are “ready”.

In a recent mentoring session with a startup they stated their intention to develop a new product. They are convinced their customers will love it.

The first question is generally: “Have you tried selling it already?”

Most startups will answer “it is not ready yet…” But in reality you can test a product even before you have completed building it.

Lean startup (http://theleanstartup.com) is a popular methodology to building startups that includes early product validation with customers as a key step in creating a new company. Beyond a particular methodology or another, creating a startup is always about iterating product, channel, customers etc as you look for a niche where your product will be readily consumed.

And despite the well known message, founders still struggle with the fear of testing incomplete products with existing customers. They shouldn’t. Chances are a startup will screw up many times in front of some of it existing customers-and telling a customer that is interested in your new feature or product that they will have to wait because it is not really ready is not the worst outcome. The worst outcome is that somebody else is faster to understand your client needs and develops a better solution for all your clients.

This is not to say you should roll-out your incomplete product to all your customers at once looking for feedback. But entrepreneurs should not be afraid to learn more about their clients before spending 2 months coding a product and should proactively try to upsell their customers on products / features they are in process of developing.

Building X and then selling millions of Y

Takeaway: Creating 2 startups at once (usually disguised as 1 startup with 2 distinct products: eg community + ecommerce) is about 1,000 times more difficult than creating just 1.

Succeeding in a startup can be very difficult. Mathematically, the odds are against you, ranging from 1/100 to 1/15,000 depending on many variables including how early you are in the startup process, depth of sponsor pockets, and your definition of “success”. Even though succeeding in 1 startup can be difficult, we find many entrepreneurs are set on creating not 1, but 2 startups!

Examples of 2-in1-startups include: building a community of sport enthusiasts to sell sporting goods, selling POS systems to create critical mass and sell payment processing, building a multi-brand ecommerce to introduce a proprietary private label, building an ecommerce whose value add is a 30 minute delivery window. Its like Starbucks saying: “I am going to create busy coffee places and then develop high traffic wifi routers to sell in stadiums.”

Creating 2 startups at the same time is really a lot more difficult than creating 1. If you need to create a community to be able to sell your sporting goods, then the success of the venture depends on both businesses being successful. The correct mathematics to estimate success when one condition depends on the other requires the multiplication of the possibilities to obtain the combined probability of an outcome (event dependent probability). Lets say each startup has a 0.1% chance of being successful: 0.1% x 0.1% = 0.0001%. Ie, In a 2-in-1-startup your chances of being successful go from 1 in 1,000 to 1 in 1,000,000, literally: “one in a million”.

On the contrary, if you are able to develop a startup that only requires to be successful in one concept or direction, you need to multiply the expected value by 1,000! That is, you are one thousand times more likely to succeed by doing one thing right.

As we posted before, we believe there are no secrets to a successful startup that you can read of a webpage (or get from a mentor session), but it appears that focusing on 1 startup at a time is a smarter decision than trying to do 2 at once. Escala.vc (and other potential investors) are generally interested in teams that demonstrate their ability to make smart decisions and whose business is more likely to succeed.

Note: Some of the above discussion can be avoided if entrepreneurs decide to focus on solving a problem, versus doing what they want to do. Once you are focused on solving a problem, the purpose of the startup is to solve this one issue in the more streamlined and clean manner, and postulating a 2-in-1 solution becomes an evidently bad plan.

A difficult way to start a startup

Takeaway: A startup created to do something the founder wants to do is a lot more difficult than a startup created to solve a problem that the founder has experienced and dealt with first-hand.

At Escala.vc, we believe there is no recipe for a successful startup. We avoid providing blanket recommendations or generic directions to entrepreneurs. Each startup is unique and will depend on many idiosyncratic factors and decisions to succeed or fail.

In successful startups, a couple of decisions usually turn out to be good, and in failures most decisions turn out to be bad.

We, like most VCs, are not especially good at predicting what startups will succeed and which ones will fail (on average the VC industry hit ratio or ability to predict winners is only about 30%) but we start to get excited when we find teams that demonstrate their ability and willingness to make good decisions.

After hearing out hundreds of founders we have observed certain indicators that, while not predicting the final success or failure of a startup, help predict the relative difficulties the startup will face to progress. Because startups are never easy, it is important to minimize the encountered difficulties. Choosing how to start a startup is one of the key decisions.

A startup created to do something the founder wants to do is a lot more difficult to execute than a startup created to solve a problem that the founder has experienced and dealt with first-hand. Being an entrepreneur is hard enough, don’t make your life more difficult.

Beyond an observed correlation, we believe there is causation:

• Lower Flexibility:  A startup that evolves continuously can better adapt to the needs of its users. If you are set on doing something in a particular way, it will be more difficult to change what you are doing. The alternative is to be set on solving a problem and adapting as needed to achieve a better solution.
• Poor Market Understanding: When you are solving a problem and you solve it, it becomes immediately clear to you who will be your next 100 or 1,000 customers. You know the qualities of those individuals, can relate to them, maybe know a bunch of them, and know how to sell them your solution: “Stop doing X in 10 hours, now you can do Y in 2 minutes”. If you just wanted to “do this great idea”, how do you know who else will use it? Will it solve their problem too?

If you are choosing to start a startup, consider making a good decision and chose to solve a problem. This approach is likely to maximize your chance of gaining traction and allow you to learn faster in the process. Demonstrating your ability to make good decisions also plays well with potential venture capitalist or angel investors.