Investing

4 Tests You Must Pass to Win My Money

Reader Resource

Get the working capital your business needs–learn more about Entrepreneur Lending, powered by CAN Capital »

Back in the dot-com boom of the 1990s, I had quite a bit of luck investing in startups. Of the six that I invested in, three companies were sold for more than $2 billion.

I remain interested in the possibility of making future investments. In the years that followed my initial luck, I have studied startups even more carefully than before. But the opportunities today are not as attractive overall as they were in the 1990s.

There are far fewer initial public offerings now. In 1999, for example, there were 480 IPOs, more than twice 2013’s 220

This has meant that the few companies that go public get lots of publicity, leading many people to have the impression that there's a tremendous opportunity to profit from investing in startups. A Google News search today for the phase "Alibaba IPO" reveals about 50 million results, following the Chinese company's Sept. 19 offering.

Today the up-front investment needed to start a company is much lower: It used to cost technology companies about $5 million, according to my 2011 interview with venture capitalist Peter Bell. Getting a first cut of an app these days could cost as little as $50,000 to $250,000. A National Venture Capital Association survey found a 64 percent drop in seed-stage capital investment in the first quarter of this year.

If an entrepreneur can make a compelling presentation that passes the following four tests, I will consider whether it has what it takes to beat the long odds of startup success -- thus boosting the chance that I will invest. I also use these four tests to guide the Babson College students in my "Foundations of Entrepreneurial Management" class in preparing their pitches for business ideas.

Related: 25 Reasons I Will Not Invest in Your Startup

1. Is there human pain that no one else is trying to relieve?

Present descriptions of people suffering from some kind of pain that no other company has tried to solve. And if solutions already exist for that pain, I want to know that yours is much better than competing products so that consumers would quickly switch to buying yours.

This question can best be answered with quotes from real people in pain. Those quotes should convince me that there's an unmet need and that you understand why they are suffering. 

One of the firms I had some luck with, SupplierMarket.com, which offers a business-to-business marketplace and was acquired in 2000 for $930 million, did 70 interviews with potential customers before asking for my investment. Those interviews convinced me that the CEO understood the customers’ need.

2. Will enough people pay for the solution?

Demonstrate that a company trying to relieve the pain has a big market available to it. Present compelling evidence that lots of people are afflicted with this pain and that a substantial proportion of them will pay more (ideally much more) than it costs you to deliver that solution.

If the revenues that could be generated by sales of your product are at least $1 billion and growing fast, I will consider that to be a big enough target market. SupplierMarket.com found that the potential addressable market for its service was a gigantic $1.5 trillion, according to its IPO prospectus.

Related: 7 Taboos of Business Pitching

3. Do you have a credible way to turn the opportunity into revenue?

Show that you have a clear idea about how to grab a meaningful share of the target market. Will you be able to deliver a better product or service to relieve the customers' pain? If so, what proportion of your customers will be willing to pay? Will they pay an initial amount or an ongoing fee? Will they be willing to pay enough for your product so your business has positive cash flow?

I will respond favorably if you have already persuaded people to pay or you can offer convincing evidence that many people will do just that. SupplierMarket.com had a clear business model. It took a fee for arranging online transactions between suppliers of, say, drill bit designs and the machine makers who needed to build those drill bits.

4. How and why should I help you?

Finally decide whether you just want my money or you also want me to help your business in another way, such as aiding with introductions to potential customers, partners, talented executives or other workers.

If you have a clear idea of what you want from me, you can also boost your odds of success if you can explain how, given the risks, you can deliver a substantial return on my investment.

If only it were as easy to pass these four tests as it is to describe them! 

Related: A 14-Step Guide to Being Consistently Pitch Perfect