Note: This article is the fourth in an ongoing series for Angel Investors. To learn more about developing the key skills needed to make great investments, download this free eBook today Angel 201: The 4 Critical Skills Every Angel Should Master or purchase our books at Amazon.com.
Entrepreneurs fall in love with their products. It’s no surprise… their product is their idea and as they nurture it, it becomes like a child to them, and who doesn’t love their child!? How many times have you sat through an entrepreneur’s pitch and learned practically every detail about the product, but almost nothing about the business opportunity. It’s great that an entrepreneur has a great product, but what she needs to understand when dealing with investors, is that the company is the product. So a great entrepreneur makes sure she spends more time talking about the company (i.e. team, market opportunity, go-to-market strategy, finances, etc) than she spends talking about the product.
The big picture company stuff is all well and good you say, but you still need to know about the product. Will customers buy? Can the company sell the product at a profit? As a co-founder of 4 software companies, Ham spent two decades working closely with customers to understand their problems and then designed and built products to address these problems. As a former product manager, Ham gained key insights into some of the important factors that determine a product’s success or failure in the market. So let’s see what he does to determine if a product is smart, differentiated and defensible.
Q: Ham, what point are you trying to make for our readers with the title of this article?
I want our readers to think carefully about what type of product the company is building. One of Launchpad’s portfolio company CEOs, Janet Kraus, was interviewed by Inc Magazine. As part of the interview, she talks about three types of business ideas: Oxygen, Aspirin and Jewelry. She goes on to explain the major aspects of each type:
Oxygen: Products/Services that people or businesses can’t live without
Aspirin: Products/Services that reduce a major pain but are not critical to survival
Jewelry: Products/Services that are considered luxuries and might be addictive
So which of these product types make for a better investment? Janet relates that an ideal situation is a product that has a mix of all three types. The example she gives is the iPhone which has aspects of Oxygen (e.g. email, phone), Aspirin (e.g. maps, fitness tracking) and Jewelry (e.g. games, music).
Finding a company with a product that fits all three types and is still comprehensible and good at all categories is like finding the Holy Grail of massive market opportunities. It just doesn’t happen that often. So I don’t recommend that investors avoid investing unless they are confident that the company has that mix. Instead, I tend to focus on finding companies with products that fall into the Oxygen category. I tend to call these “need to have” products as contrasted with “nice to have.” Personally, I believe these companies make great investment opportunities, especially when risk is taken into account.
Q: Why don’t you invest in Jewelry?
There is nothing wrong with luxury markets - just ask Tiffany & Co. Jewelry-like products require a different approach to investing because the customer is not a specific set of well-defined individuals you call up on the phone and talk to, it is a demographic (e.g. wealthy urban women or teenage boys). You somehow need to understand what the buying habits and interests of the broad demographic are. If you spent much of your career selling to a particular demographic, you are probably qualified to determine whether customers will buy the product. But most angel investors are not market experts with this type of experience!
To better understand the challenge you face when researching a “Jewelry” company, let’s take a little test. Suppose you are thinking of investing in a new video game company. They’ve built an awesome new game and you and your kids really enjoy playing it. Now, ask yourself the following question: “Am I confident that 5 million American Teenage boys, ages 12 to 18, will play this game for the next 3 years?” If you can’t answer this question, you should think twice about investing.
I have to admit, on occasion I invest in a “Jewelry” company. Maybe I find the CEO to be compelling, or maybe I just love the product. But, I make sure that these investments represent a very small percentage of my overall portfolio, and I accept that I am taking on greater risk because I have been unable to really verify the buying priorities.
Q: How do you go about the process of determining whether a product is “Aspirin” or “Oxygen”?
As noted above, I start with the following question: Is the product a ‘Nice-to-Have’ or a ‘Need-to-Have’? As we discuss above, Aspirin (nice-to-have) helps reduce pain but isn’t critical for survival. Whereas, you can’t live without Oxygen (need-to-have). Keep in mind that this is a continuum, and that the real difference between the two categories is just a market size question and a question about buying priorities - inevitably the oxygen buyers are just a subset of the Aspirin buyers.
With that in mind, I reach out to current customers and prospects for the company’s product. During my reference checks, I focus some of my initial questions on understanding the customer’s key pain points. I ask the following two questions:
What problem does the product solve for you?
On your list of the top problems in your organization, where does solving this problem fall on your priority list?
By asking these two questions, you learn a lot. First of all, you hear in the customer’s words what problems are solved by the product. Does that match what you are hearing from the entrepreneur in her pitch? If not, this is useful information you can pass back to the entrepreneur. If it does match, then you know the entrepreneur is doing a good job of listening to the customer.
With the answer to the second question, you are gaining critical insight helping you gauge where the product falls on the Aspirin/Oxygen spectrum. If the customer tells you that the product solves one of his top three problems, you are in Oxygen territory. Anything outside of the top 3 priorities and you are now in Aspirin territory. But don’t rely on just one or two customer reference checks. This is one area where you need to dig deep during your due diligence!
Q: Okay, so the customers and prospects tell you that the entrepreneur is selling Oxygen, how do you determine if the product is differentiated and defensible?
First of all, to determine if the product is differentiated, we do a competitive analysis that combines our own research along with market outreach to customers and prospects. During our reference calls, we ask the following questions:
How are you solving your problem today?
Have you used similar products before?
Did you look at any competitive products?
Are you considering any alternative ways of solving the problem?
It’s important during this stage of due diligence that you have one or two market experts helping with your research. You don’t want to be blindsided by a competitor that was already very well-established in the market.
The key when looking for differentiation is to look for distinctions that matter to the customer. As we noted above, founders are in love with their product. They know every detail. They are really close to the nitty gritty - usually too close. When asked about differentiation, founders will frequently cite differences which are extremely nuanced. Even if they can even be detected by the typical hurried customer, they often will not be a major value driver from the customer’s perspective. The investor’s job is to figure out the differentiators that matter to the customer and make sure they are present in the product.
Second, to determine if the product is defensible, we look at the question of whether hard won customers can be retained, whether pricing power will hold up and whether the margins in the business are likely to be squeezed by competitive or environmental factors. Retaining customers is all about delivering a strong value-proposition relative to your price and relative to the other things on the market. Does the company have a compelling offering?
Defending pricing and margins usually takes one of two forms: either keeping competitors out through some sort of blocking rights like intellectual property (e.g. public forms such as patents, trademarks, copyright or private forms such as trade secrets or proprietary know how), or finding ways to keep customers in. Keeping customers in requires some form of the classic economic concept of high-switching costs. In the case of Facebook, the high switching costs would be all the friends, updates, photos and data you have collected on the system and cannot figure out how to move elsewhere. On a personal computer platform it might be all the software you have invested in which is only compatible with that platform. In cameras, it might be getting someone to invest in a lot of Nikon lenses over time so they will never switch camera brands. In case it is not obvious, businesses with high switching costs are not that easy to build, especially in today’s internet-centric world where competitors’ products are just a quick Google search away. More often than not, efforts to bake in switching costs just come across as product limitations which irritate consumers and slow adoption. Consumers are pretty savvy at avoiding lock-in and format wars when they can. As much as it hurts to admit it, sometimes the best lock-ins are an accident, or at least very subtle and sneaky in the beginning.
One closing thought here: “first mover advantage” is not a type of defensibility. Entrepreneurs cite it all the time, but as Christopher discussed in the past, getting an actual advantage from being a first mover is really rare and really hard.
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