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Founder vs. Business Model Paradox
Balancing founder qualities against business model during the investment process
One of the key challenges for Sturgeon Capital as an early stage investor in emerging markets is balancing the emphasis we place on the qualities of the founders versus the strengths of the business model. The former are qualitative and hard to put a finger on, whereas the latter can be quantified and judged in a more objective fashion. For business models, we can look at comparable companies in developed and more-developed-emerging markets to see how they have evolved over time and what they look like at scale. For founders we have to rely on more of a gut feeling, gleaned from the time we spend with them and the experience we have with other founders, to judge their ability to ride the turbulence of building a startup from idea to scale. There are many other considerations (cap table, market size, competition, etc.), but I want to focus on these two points for this post.
The background for this piece is 32 early stage investments made across nine markets over the last five years. The majority of these have been between Seed and Series A, with a focus on B2B Software, Marketplaces, and FinTech. Of the 32 investments, we have had one write-off, and the remainder are still hustling their way to solving some of the fundamental problems affecting the day-to-day lives of businesses and consumers. One point before digging into this question: we have been lucky enough to work with exceptional founders, something that they must be even to attempt to build a startup in these markets. For the avoidance of any doubt, this piece is in no way a critique of any of them. As with anything in life, however, there are exceptional and then there are unique individuals who are able to do what others are not. These people really are the “unicorns” of the startup world in their rarity and abilities.
My takeaway from these investments is that founders should always be the reason why we invest in companies, and this can be true even if the business model today does add up 100%, and that business model is never a reason to invest on its own. Our modus operandi as a VC is to efficiently allocate capital, both human and financial, to the opportunities that can generate the highest returns. If we look at cases where we overemphasised the business model during the due diligence process, we find ourselves in situations where we have to get involved in the operational side of the business. Whilst we have the ability to do it, this is not our core competency and is fundamentally a misallocation of our human capital, compounding the prior misallocation of financial capital. Looking at the outperforming companies in the portfolio, the “business models” we invested in originally have changed almost beyond recognition, other than the company names and the teams involved. Their success has directly been a function of the qualities and abilities of the founder(s) to iterate to the point where they have developed and implemented something profitable and scalable in their markets, with the iteration being driven by new learnings gathered and synthesised to then inform execution.
This observation is not a call to discount business model and focus only on founders. To do so runs the risk of being taken in by the archetypal “snake oil salesman,” a common character in the world of venture. The business model has to add up with a margin for error in the founders’ and our forecasts. But, investing as we do on companies around Seed or Pre-Series A, we look at business models from a top-down perspective as a negative screen, i.e., why NOT to make an investment. For instance, one can look at the overall margins available across an industry value chain and how they are divided between different stakeholders. Other flags might be the anticipated consumers’ disposable incomes and the proportion spent on particular goods or services. Or, perhaps, the IT budgets and profit margins of potential business software customers to assess their ability to pay for a product. This correlates to the reality that great founders have almost always disrupted how industries operate, therefore over-indexing on what a business model looks like today risks missing out on the opportunity that can truly disrupt a market.
On the other hand, founder assessment is a positive screen with a high bar for excellence that must be met before we invest. Quantifying that excellence is like a proverbial piece of string. In an ideal world, we would have the chance to spend time with a founder over multiple months or indeed years, to track their execution through cycles and challenges. We know that being data-driven is fundamental to the efficient allocation of capital in scaling a business, and this can be demonstrated through how a founder presents and operates against that data. Beyond this there are the innately qualitative characteristics such as grit and perseverance which will play a crucial part in long-term success. The ability to curate talent and culture better than anyone else, inspiring 10X individuals to work together seamlessly around the vision of the founder, is another crucial aspect. Time and reference checks are about the only things that help to capture and demonstrate these points.
To reiterate the point from the opening paragraph, founders and business models are by no means the only considerations we factor in. However, a key learning over the last five years is that the best business models are only as good as the quality of the founders building them. When we look at deals where founders do not meet the highest bar of excellence, then no matter how appealing the business model, we pass 99 times out of 100. When we look at deals where the business model today is unclear, but we have founders that are top percentile, then we must take a step back and think about what is possible and put faith in the founders to execute, with our erstwhile advice and support where we can add value.
As a team, we continuously work to develop and improve our investing framework. Founder assessment is a fundamental part of that, and we will be publishing a follow-up post to this one with a breakdown of character traits that we believe are indicative of the top-percentile founders. If anyone reading this has suggestions on what should (or should not) be on this list, then we welcome your contributions.
Footnote: A good resource for understanding and appreciating ‘peak performance’ is this interview with Dr Gio Valiante, who was the Head of Performance at Point 72 (previously SAC Capital) - one of the most successful hedge funds out there.