You may not remember what was happening in information technology around the turn of the century (It’s known as the “The dot-com bubble”). For many people, the lesson we’re talking about in this article was learned the hard way.
According to FactSet, in the early part of 2000, IT constituted close to 35% of the Market Capitalization of the S&P. And, in about a year and one-half, when the dot.com bubble burst, it was generating less than 1% of the S&P’s profits. In other words, much of the trumpeted value of numerous young companies was based on little more than concepts.
Pretty basic, right, but you’re being asked to invest in little more than a concept, aren’t you? Be sure to ask for details about the following:
- Is there a product ready for sale?
- If so, is it still at a developmental stage (“alpha”), testing customer use (“beta”), or is it commercially viable and now being regularly used by customers?
- Are they happy with it?
We don’t mean to pick on information technology. It’s just the most eye-popping example that comes to mind, and it happens in every industry to one extent or another. So that’s why we encourage venture investors to ask the following questions:
Where in the development process does the product/service stand? Is it still in the developmental stage (e.g., still a prototype), or has it been tested with real customers (but still evolving) to determine appetite, pricing optimization, design, etc.? A company offering an investment at the developmental stage may be of interest to you, but it should be offering a higher potential return on investment because the risks are so much greater — it is more likely to fail because it is in an earlier stage.
If beyond beta, is it commercially viable and now being regularly used by customers? What percent of customers are repeat purchasers/users? How happy are they with it?
Can management demonstrate to you what is the per-unit cost to produce, market and sell the product? If it costs more to produce and sell than it returns, and they are relying on falling costs when a certain volume is achieved, probe harder.
Have they tested pricing points to ensure a viable profit margin that supports growth and time to gain market share?
Can the business compete successfully against larger, household-name competitors who can undercut their prices on one line of business for an extended period of time?
Has the company established a supply chain of third-party vendors, and in what stage are negotiations to ensure deliveries and other support?
Investing in a company that has a product, revenues and repeat customers is a safer bet than one that is still in alpha, or, even, beta stage. But, then again, the projected rewards for the investor in an early stage venture that does succeed is commensurately higher than its more advanced cousin. Caveat emptor, investors!
This is one of nine questions we propose are important when considering an investment in a venture-stage company. If you’d like to see all nine, please go to our Nine Leaps of Faith in our Knowledge Base.
