A framework for picking and funding your business idea
How do you decide whether to work on an idea you have? And how do you finance it? These are key questions that every entrepreneur has to answer. Here's the framework we used to pick a good idea to work on, and the four financing options we explored.
This is part two in a three-part series. Part one was about how we defined success for our new, creatively-titled venture "Next Biz". This post is about how we evaluated the different paths to maximize our chances of success. Part three covers the details of buying Codetree.
Best Path to Accomplish Our Goal
The first step was to define what success looked like for us. The next step was to figure out the path that would give us the highest chance of getting there.
There were two things we need to figure out:
What problem would we work on solving, and
What financing model would be most likely to lead to a successful outcome?
Choosing a good problem to solve
We’ve built four successful SaaS businesses, and consulted with companies that have done $100M+ in revenue. We have the battle scars and seen them on others. Based on these mistakes and wins, we built a set criteria to evaluate opportunities. We broke these criteria down into the "must haves" and the "very nice to haves".
Here are our must have criteria:
1. Does the business HAVE to solve the problem?
Does the product solve a hair on fire problem ("I'm a sales person and need a CRM to track my deals")? Or is a must-have ("I need to process credit cards online")? Or core to business ("I need a member management system to run my gym")? Are we selling something where the customer’s thought process is "which [blank] are we going to buy" rather than "do we need to buy [blank]"?
In short: you want to make sure you're solving a hair-on-fire problem (click to tweet).
Make sure you're solving a hair-on-fire problem
art by revangale
2. Clear return on investment
It’s much easier to sell revenue growth or directly-attributable savings instead of time savings.
3. Market size > $30M
Sequoia invests in large markets because your upside is not capped by a small number of potential customers. Large markets also have lots of niches to serve - especially important for bootstrappers.
4. Can we segment and reach customers?
It’s much easier to e.g. make a list of your potential customers and call them up (e.g. "a tool for VPs of HR") rather than a horizontal tool where “anybody is your customer”.
5. High Lifetime Value (LTV)
It should be valuable enough and core enough that customers rarely churn.
6. 10 year check
Can we imagine yourself doing this for 10 years and enjoying it? We’re in this for the long haul so let’s enjoy the ride.
7. Is the nature of the work required generally enjoyable?
If not, why on earth would you start?
8. Operationally simple
CRUD apps are preferable to businesses that scale with humans, or that have lots of software complexity.
9. Software errors aren't catastrophic
If you’re running Heroku and it goes down, your customers bloody hate you because they’re losing money. If you’re running a help desk and it goes down, it’s an all-hands on deck emergency. It's only marginally less stressful than if you’re running Heroku. But that margin lets us sleep better at night.
10. Gut check - does this feel right?
We also ranked every opportunity against these "nice to have" criteria.
11. Growing Market
A rising tide lifts all boats.
12. Self-service signup
Can we imagine a scalable acquisition channel that doesn't involve Inside Sales or Field Sales? We don’t enjoy inside or field sales, so self-service sales is preferable.
13. Recurring revenue?
It's great that you're not starting every month at 0, but with a cushion of revenue to budget against.
14. Straight software
One of the last businesses we ran was essentially a data-entry service for gyms. We had a team of 10 people who entered data and thus delivered value for our customers. Without them the business didn't work. This was a more complex business to run than one that only used software to deliver value to customers.
15. Average Revenue Per User (ARPU) per month > $300/m
It’s hard to get to scale when ARPU is low.
16. Selling into departments at companies
A manager spend his or her company’s money for their team is a low-friction sale. Much lower than spending your own money or buying for a large company. This also enables a land-and-expand strategy where you spread from department to department.
17. Decision maker doesn't need approval to buy
The price point is "cheap" (under $1k/m). This is low enough to fly under most companies’ expensable limit.
On-premises software? No thanks!
21. No critical partners or regulation
The fewer obstacles between us and success, the better.
22. MVP Bootstrappable in < 3 months
This lets you get customer feedback (and revenue) ASAP.
23. Are we good at it?
We wanted to stay in our "Circle of Competence" to have a high chance of success.
25. Are we interested in the problem?
This helps, a lot. When a problem is intrinsically rewarding to work on, the hard times are easier to get through than if there's an extrinsic rewarded.
25. Do you feel good about solving the problem?
Where are we on the spectrum of selling cigarettes to children (bad) vs curing cancer (good)?
26. Do we like the customer and would we enjoy helping them?
Always good to like the customers you spend your days talking to and helping.
27. Is this a good fit for our skills and temperaments?
We like businesses that will do well if you put one foot in front of the other. Build a good product for a painful problem, know who you’re selling to, and sell it. The alternative is a business that has an inflection point that may or may not happen. For example, a social network that makes money only after it gets to a certain size.
We tried not to make stupid mistakes
You can see that most of our criteria were relentlessly focused on helping us avoid being stupid. We’re big fans of saving our cognitive cycles. One way to do this is to use checklists, so we made a spreadsheet to evaluate the businesses we thought about starting.
Once we knew our criteria, we needed some ideas. The basic process we used for finding an idea was:
Run them through our criteria spreadsheet
Do a deep dive on ones that passed the filter.
We took three approaches to generating ideas:
What problems did we had in our own lives, our clients’ lives, or running previous businesses?
What internal tools had we built to solve our own problems or have we seen others build. This is indicative of such a painful problem that they took steps to build something to make the pain go away.
As an example at our last business we built these internal tools:
- Customer retention email tool (e.g. Customer.io, Vero)
- Outbound cold email tool (e.g. Tout)
- Dunning tool (e.g. Churnbuster)
- A set of monthly SQL queries to calculate new signups, churn, etc. (e.g. Baremetrics)
We sorted a list of SIC codes by market size and looked at businesses who sold to those customers
We generated about 30 ideas. Here are the ones we seriously considered:
Tool for Product Managers
Having been PMs before, we identified five problems that we know most PMs faced during their day to day. We spoke to ~20 Product Managers at companies like Slack, Hootsuite, and GoDaddy. Ultimately we learned that the biggest pain PMs have is around communication. The other pains needed vitamins, not painkillers. We weren't excited about solving the communication problem, so we passed.
This tool would help a marketer build relationships with people who had an audience that the marketer wanted to reach.
Here’s how we stumbled on this pain. When we were exploring the PM tools idea, we built levelup.pm. This was to build an audience of Product Managers. The idea came from this excellent talk by Iris Shoor. LevelUp.pm has 120+ evergreen categorized resources to help PMs get better at their jobs.
To get the word out, we took this excellent advice from Alex Turnbull to start building relationships with influencers.
This process was a royal pain in the butt, but massively valuable. A tool could automate a lot of the grinding and we think this could be a big business. We ultimately passed because serving marketers is not in our Circle of Competence.
Recurring Processes Tool
Many businesses run on recurring tasks that involve moving data between systems. We think there’s an opportunity for a recurring-checklist-meets-API tool so managers can:
Make sure the right work is getting done to the right level of quality and
Save line employees a ton of time when doing the work
The problem here is that there aren’t a ton of people looking for a solution, so the sale is educational. First, people need to understand they have the problem. Then they need to understand why your product will solve that problem better than other products. This business fails the "which [blank] should we buy" test. It's more like "I didn't even know that we have a problem that your tool would solve."
WeChat on North American Platforms
We think there’s a big opportunity to be had by connecting local service businesses to their customers via a messenger app. Why? Because you just need to look at Wechat to understand that the future’s here, it’s just not evenly distributed yet.
In the last few months both Facebook and iMessage opened up their platforms to "bots". If you believe WeChat is the future, the winner won’t be AI-driven bots, it’ll be mobile-optimized apps that run in a messaging platform. Dan Grover, a Product Manager at WeChat has an excellent overview of what he thinks will be successful. Another great resource is this great a16z podcast where analyst Connie Chan talks in detail about why she believes the WeChat model will be successful in North America.
We think this is a legitimate billion dollar business opportunity. But we passed on this because our definition of success doesn't include taking a homerun-or-strike-out swing.
Software Issue Tracker
We’ve done a bunch of engineering management work over the years. We've looked for issue tracking tools that are easy to use and just opinionated enough. JIRA is the beast in the space, but it doesn’t work well for the approach we use. It's also frustrating to use. Fogbugz is probably the closest to what we’d use. But it seems like the redheaded stepchild in the Fog Creek family (apologies to redheads, we ❤️ you). Pivotal is a good tool but too opinionated.
As more companies become software companies, issue tracking is a large, growing market. It's a must-have, and it seems like there’s lots of opportunity. We’ve been devs and run teams at bootstrapped, venture-funded, and big companies. This was squarely in our Circle of Competence.
What we decided to build
Ultimately, we decided to build an issue tracker for software teams. An issue tracker checked all the boxes on our spreadsheet except "ARPU > $300" (which we could probably fix in the long term) and "MVP Bootstrappable in 3m" (the surface area of an issue tracker is broad).
Other reasons we decided to build an Issue Tracker
Every company is becoming a software company. Those developers will need tools to use to build said software. The market is huge and growing.
Once you get past a team of 1, an issue tracker is a must have. It’s not "do we need an issue tracker" but “which issue tracker will we use”?
We recently tried to find an easy to use tool to fit a fairly straightforward workflow. It was painful.
We have informed opinions from 45 years of combined software dev experience about what works and what doesn’t. We know how a tool can be paved to make it easy to do the right activities that encourage shipping good software.
Does the world need another Issue Tracker?
The biggest risk to building something is that nobody wants it. To de-risk this, we're big fans of resegmenting an existing market. To do this, we slice off a piece of an existing large market that is underserved by existing solutions. A good example is Pipedrive making an easy to use and cheap CRM for SMBs who would find using Salesforce to be overkill and expensive.
Is his excellent podcast called Seeking Wisdom, David Cancel calls this concept "innovation vs invention". Innovation means taking an existing solution to a painful problem and making it better. Invention means you're creating something brand new, and is a lot riskier. (click to tweet)
We think there's room for innovation in most large markets. Issue Tracking checked all the necessary boxes for us and we didn't want to take the higher-risk path of inventing something from scratch. So Issue Tracking was the problem that we wanted to solve.
The next question was: what financing approach should we take?
Build or Buy or Bootstrap or Raise
The mythologized entrepreneur’s journey involves a flash of inspiration, a boatload of VC money, and some hard work. A multitude of riches are the spoils. But it turns out there are more options to finance a company than the ones shared by your favorite breathless journalist. (click to tweet)
Here are the four options we considered:
Build from scratch and raise angel / VC money
Build from scratch and bootstrap
Buy a large business with debt and / or equity financing
Buy a small business outright
We ended up on #4, but we'd like to share our thinking on all four options.
1. Build from scratch and raise angel / VC money
This is the path that most tech entrepreneurs in 2016 think is the only path. Our definition of success made this the least attractive option. Two of us have had experience as execs at VC-funded companies. The challenges go beyond finding product/market fit, which is tough enough. They also include fundraising, managing a board, being fireable, having a diluted equity stake, and being pressured to spend money faster than necessary. These were all problems we didn’t want to deal with. We’re not averse to raising money as growth capital, but raising from scratch didn’t make a ton of sense for us.
Venture returns follow a power law distribution. This means the vast majority of returns re from a few winning portfolio companies. For example, as of Jan 2016 AirBnB was worth $25.5B, while the other 939 YCombinator-funded companies were worth $40B combined. What are the odds that we’d be an AirBNB? Slim to none: it’s a lottery ticket. If we weren’t going to and didn't want be an AirBNB, the odds of a successful outcome going the venture route were zero. (click to tweet)
2. Build from scratch and bootstrap
We'd gone down this path a few times and was our default. Back in the day building from scratch was exciting. But now, older, possibly wiser, with more family and less time, it was daunting. We’d spend a year to figure out if there was really a "there" there. Like a solid safety school, we were resigned to this path if none of the preferred choices worked out.
3. Buy a large business with debt and / or equity financing
Constellation Software is an interesting company that does private equity-esque transactions in tech.
They’re an $11B publicly traded company whose model is to:
Buy software businesses making ~$200k+ ARR in desirable markets
Incentivize the business owners to grow the business while being hands off
Their model is similar to Berkshire Hathaway's, but for software. If you want to learn more, their IPO Prospectus (CMD-F to search for "apr 3 2006" in the page) lays out their strategy. To an outsider’s eye, it seems fairly consistent even 10 years after they’ve gone public.
Running across Constellation piqued our curiosity. We modeled out what kind of cash flow we'd have if we bought a large business. We even cold emailed and spoke with a few companies in segments that we thought would be good acquisition targets. (Dental Practice Management systems was one space - thank god we didn’t end up there).
Here are the problems with buying a large business with debt and/or equity capital:
First, the core skill you need to make this fly are finance skills, not software.
Borrowing a lot of money - likely with personal guarantees - made us think it’d be hard to sleep at night.
We’d most likely buy a slow growing but stable, vertical solution. This is because growth is expensive. A fast-growing tech business is going to sell for a crazy revenue multiple. This high multiple will prevent you from paying down your debt from the business's cash flow. For example, we talked to a high-growth SaaS business that had negative earnings. Their asking price was $15M. If we financed that purchase there would be no way to pay down the debt financing because all the cash flow was going to fund growth.
If we raised debt and equity, we’d spend 7 years paying back a ton of debt. And unless we got an unlikely sweetheart deal from investors, our ownership percentage would have been less than 50% combined. Based on how we defined success, this scenario wasn't what we were looking for.
This was an extremely useful exercise to go through. We’ll likely go down this road later. Buying stable and predictable cash flows with leverage can pay massive dividends over time (click to tweet). It was a worthwhile investment to learn about Constellation and a little about private equity.
4. Buy a smaller business outright
"The reason for buying small SaaS businesses is that it's so hard to start anything from scratch. Even a business doing only $5,000 in MRR has validated something significant, and that makes the business valuable." (click to tweet)
- Hiten Shah
After Rob Walling started Drip, he said something like "now that I know how much work it’ll be to start something, I’ll never do it again". He had a good basis of comparison because he bought and grew HitTail before starting Drip. We sold a SaaS business a few years ago and were curious about how big a head start we could get if we bought a business.
Buying a small business can give you a good headstart
art by revangale
So while we explored buying a large business, we also explored buying a smaller business outright. This was the most attractive option. It enabled us to control the company without taking on massive debt. It also giving us a headstart on finding product/market fit. Being able to phone up just ten paying customers on day one to understand how to make the product better is a big win (click to tweet). Plus, revenue on day one is always nice.
When we ended up
So on Friday May 13th 2016 we had decided to focus on the problem of building an issue tracker for software teams. And we had a preferred approach: buy a small business, with bootstrapping as a backup plan.
It took a year
To get here took introspection, many (frustrating) conversations with each other, lots of spreadsheet modeling, conversations with all kinds of willing customer development subjects, tons of reading, research, and cold emailing, and a bunch of dead ends (or "learning opportunities"). It took us a year working part time to get to this point. But we felt good about where we ended up.
Part three is about how we ended up buying Codetree. We'll talk about how we ended up at the purchase price, share actual emails from the negotiation, talk about the risks of buying Codetree, and a whole lot more.
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