Are you a lemon? How to send strong signals to investors.
I was looking for a marketing agency recently and was surprised at the pushback when I asked for references.
“Too much hassle for our clients.”
“We’ve earned the right not to give references.”
“Our work speaks for itself.”
I didn’t hire them. No matter how great their portfolios looked their work did not speak for itself, which is why I wanted references.
It got me thinking about lemons.
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The Market for Lemons
You may have heard the term ‘lemons’ applied to used cars. It’s from a 1970 paper by economist George Akerlof who, along with Michael Spence and Joseph Stiglitz, won the Nobel Prize in economics in 2001 for their work in asymmetrical information.
Say you’re buying a used car. You don’t know if it’s good (a peach) or bad (a lemon). But the seller does.
As you negotiate you’re going to decrease the amount you’re willing to pay because you’re uncertain. You might get a lemon.
What if the buyer is really selling a good quality car? How can they convince you? They might offer you an extended warranty or rely on a third-party to vouch for the car, e.g. “Certified Pre-Owned.”
Akerlof was interested in how markets fail when buyers and sellers have different information. I just wanted to hire a marketing agency!
Just looking at a portfolio isn’t enough because bad agencies look the same as good ones.
Talking to actual customers makes it easier to separate peaches from lemons. Good marketing agencies will always want to give references because it’s the easiest way to signal that they are high-quality. Ideally they can then charge more.
Let’s see how this applies to startups. By the way, in the market for lemons the entrepreneurs are the used car salespeople.
Information asymmetry in startups
No matter how clear your pitch is, there will always be a large amount of unknowns in your business. How do investors separate the peaches from the lemons?
You already know that investors are looking for a huge market, strong demand, a novel solution and a business model that makes money. They also want a clear way to go to market.
Oh, and strong traction, IP and an amazing team.
It’s difficult to check all those boxes. And unfortunately, even checking all the boxes does not automatically result in an investment. It’s partly because your competitors might check the same boxes too.
No matter how much you’ve achieved so far, investors will always be uncertain about what you can do in the future. As we’ve seen time and time again, in startups past performance does not necessarily predict future results.
But that also points to a new way to think about your pitch.
Evidence of success vs signalling future success
Instead of trying to brag about your accomplishments, what if you looked at every aspect of your pitch as a way to signal why you’ll be successful in the future?
Let’s take a look at three examples:
Most startups struggle with how to communicate traction, mostly because they’re worried their numbers are not big enough or growing fast enough.
Instead of the biggest sales number, you should highlight the number that was the most difficult to achieve. You signed 10 enterprise clients but one had the most competitive, complex procurement process. Or they are the most influential in their industry. Replace a page of 10 logos with one big logo and a case study (shrink the other 9 logos and keep them in there).
If you’re building a product your most important early stage metrics are your product metrics. Sign-ups are not the most difficult. Engaged usage are.
Degree of difficulty signals so many positive things: the skill level of your team, the quality of your product and your competitive advantages.
Many entrepreneurs do not know how to make their team sound impressive. PhDs and prior experience are strong signals and might be pre-requisites in some industries like life sciences.
But good credentials aren’t enough and aren’t a barrier to raising money.
Showing strong founder-problem fit is just as important because it signals that you’ll stick with the problem for the long term. It answers the question: why do you care?
Also, how did you meet your co-founders? How do your skills and personalities compliment each other? I rarely see team origin stories in a pitch but it’s the DNA of your startup and a very strong signal of future success (or failure).
IP in the form of patents or research is a strong signal. Not only of potentially unique technology but team-problem fit.
But most startups do not need patents. That doesn’t mean technology isn’t important as a signal.
What process did you use to develop your tech? How many users did you survey or talk to? What experiments did you run. Which ones failed? If Edison was pitching a lightbulb company today his 2,774 failed experiments would have been a strong signal of future success.
Presenting a beautiful product is not the goal in a pitch. It’s more important to show how you got there. The process that built that product with that traction is a strong signal that the future is bright.
The dark side of signals
Unfortunately, the use of signals by Angels and VCs has resulted in conscious and unconscious discrimination. A lot has been written about this but progress has been frustratingly slow.
VCs are hopefully becoming more aware that who they agree to meet and who they invest in (or don’t) is a strong signal of their own biases. More than what they say about diversity. Founders, like investors, should use all the signals at their disposal to decide who they want to work with.
How to broadcast strong signals
Investors want someone who is coachable. But they also want a leader, not a follower. A strong signal of coachability is to get a coach/mentor. Mention that when you pitch.
Investors like serial entrepreneurs but you’re a first time founder. Highlight life experience that’s entrepreneurial. Talk about your years of experience with the problem you’re solving if you don’t have years of founder experience.
Even successful founders with successful businesses get confused about why their pitch doesn’t seem to work.
One of the reasons is because past success and current traction do not speak for themselves.
Investors know there’s still uncertainty so they rely on signals that help them figure out if you’re a lemon.
It's a combination of "good founders don't need coaches" (untrue) and not knowing how to find a good coach (a real problem).
I like the reference to a coach or mentor. You never see a team go out on the field or rink without one. Why do so many business owners play without one?