Here let me read it to you. Best to listen straight off Spotify though, the browser version is buggy.
Two reasons we run for the exits
Are you looking to raise finance or get a project approved, but keep getting rejected? This week, a tip on why that might be.
We’re not pro investors, but we do the occasional angel investment in businesses outside our main operation. We’re pretty chilled about it: it ain’t Shark Tank, we’re more Wobbegong Tank. It’s fun, it has strategic benefits and keeps us tuned into the wider business world. We mainly invest because we’ve rated the founder’s previous work elsewhere.
We’ve said no to plenty of others, and it’s usually because they presented the Magic Compounding Spreadsheet. It’s the second of two Code Red Alerts.
Code Red Alert #1: “Just x percent”
All pitches start with a solution to a perceived need. Let’s say the product is a bedside water glass with a hinged lid, so you don’t have to worry about slugging down unseen moths and bugs in the middle of the night*.
So they get some Total Addressable Market stats.
100% of people in the market sleep! If we can get “just 1%” of that market in the first five years, that’s net sales of 3.3 million in the US!
1% sounds low and doable. But not as low as the actual sales they will achieve because selling 300,000 of anything is a superhuman task. And it has no correlation to how good the product is.
Also don’t use the word “just”, it suggests you’re a serial underestimator of how long things take, how much they’ll cost and how hard it is to get customers. It’s like tradies who say “too easy”. There will be no easiness.
Code Red Alert #2: The Magic Of Compounding
Then comes the Magic Compounding Spreadsheet. It starts with a modest column 1. Lowball revenue. Costs kept to a minimum but it still makes a loss. Seems fair, that’s how Year Ones are.
Year 2 has a growth percentage attached. Let’s say it’s 40% sales growth per year. The cost percentage rise is much lower, because there will be economies of scale out of those fixed costs. It still looks achievable at this point.
Then it’s click and drag time, and with one simple mouse move the numbers go straight through to Narnia. Drag those growth figures over Year 5 and now revenue has gone from one person at a café table to eleventy million. Costs remain modest. The profit projections go full Pablo Escobar.
Software startups are the strongest candidates for Compound Magic, because there’s no significant cost of goods increase with each new customer. I’m looking at one now that predicts a two-person startup will be making $29M clear profit at end of year 5.
I’m not trying to crush your hopes and dreams but that is not going to happen. Pretty sure it’s never happened. The fact that you’re presenting it makes it look like you’ve never managed a real-world business in your life.
It does not make us think: let’s kick in a six-figure amount for you to learn about danger.
Telling us the bad things will impress us
Shiny-eyed optimism is terrifying for investors and your boss.
You do not look like a high-potential business person when you present these world-beating projections. You look like a grinning Labrador when it’s time for a walk.
It shows that the bad things that are an inescapable part of business will take you totally by surprise, and you will have no idea what to do.
You’ve put a SWOT analysis in your pitch deck, but none of those Ts seem to play any part in your future P&L. It’s like predicting you can play right to the top levels of a computer game the first time you play it.
Don’t get me wrong, compounding is great. We’ve all seen the Warren Buffett and Charlie Munger quotes, and it’s all true. It’s just not going to happen at the rate you reckon. Even if your product takes off, it’s real hard to maintain that year 1 growth percentage in year 5, because these are big numbers now.
There may not be economies of scale
The idea of bigger always being more profitable just isn’t true. Company mergers and acquisitions are always justified by “back-office synergies” – ie firing people – and there’s plenty of evidence that the benefits are routinely overestimated. Turns out it was all about ego and the winning CEO getting paid more, who could have seen that coming.
We’re at an interesting point of our own growth. We’re at a size that’s really profitable. Flat management structure. Single person in control of major projects. It’s great.
About 25% beyond our current revenue lies danger. You start needing lots more desk-job roles like HR that sap your bottom line. Projects start getting a one-size-fits-all process applied to them, which means extra work and more costs. Your staff feel frustrated by all the process, so they don’t work as hard or look out for ways to avoid waste. You can’t fight the system, they think.
We’ve been there before as employees elsewhere and it’s not what we want. It’s easy to underestimate those growth costs.
What do you do?
Talk to people who won’t be direct competitors but own similar businesses. Don’t go to them and ask “can you show me your real-life books?” because that’s lazy and rude. Put a draft P&L together for your future business and ask them to mark your homework.
Ask them about all that went wrong when they were growing.
People love to tell war stories. I’d tell you the story of how we thought we were a year away from the payroll tax threshold, but in fact had passed it two years ago and now owed over $100K in back-tax.
Talk to real business owners and you’ll get a long list of bogeys you can include in your pitch as risk factors. Investors will think you’re a pro who covers all bases.
That’s a much more reassuring place to put your money.
* Whenever I suggest stupid joke products and businesses they usually come true a few years later, so watch out for this one in the Innovations Catalogue.
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