One thing I have learned for sure about investing in startups is that entrepreneurs love to exaggerate how much they will sell next year. No matter how little they have sold in the last 12 months, they are sure to predict a gigantic percentage increase in sales for the next four quarters.
This leaves investors in a challenging predicament. They must decide if the entrepreneur is believable or a serial prevaricator. My advice is to screen out the liars as quickly as possible. Also avoid dealing with those at the other extreme, people who always talk about risks and lead an investor to believe that the venture has no chance of success. Upon encountering either extreme, steer clear of investing in those companies.
So how can you find that rare entrepreneur who is both optimistic and believable? The answer is to give her a simple test: Ask her to present you an ambitious, yet credible sales forecast.
A credible sales forecast relies on doing a little market research. My 29 "Foundations of Entrepreneurial Management" students at Babson College made solid 12-month revenue estimates in three days so I know it can be done without spending a huge amount of time or money. Here are five easy steps for doing so:
1. Describe the business concept simply and clearly.
You can't expect potential customers to say what they think about your business unless you describe it clearly and succinctly. Try to articulate in a few simple sentences what the business does and why it's better than other ones already in operation.
Here's an example: One of my student groups planned to build an app that would enable people with private parking spaces in a given city to rent them to individual travelers. The renters would receive a guaranteed space at a reasonable price and the landlords would take in extra money.
Make sure you can convey your business idea in clear terms.
2. Develop questions to estimate demand and price.
To estimate demand, be sure to ask people clear questions. Ask respondents to pick on a scale of 1 to 5, "How likely are you to use the service?" Next find out how frequently they would use it (with possible reponses ranging from once a year to, say, once a day). Also inquire how many units a respondent would buy each time. Provide a range of possible prices and find how much they would be willing to pay.
3. Choose electronic means to deliver the survey.
I am hardly an expert on this topic but many of my students used a program called Survey Monkey to distribute the survey. They also used this program to analyze and present the results.
4. Send the survey to 100 people in the target market.
My students worked in groups, with each member of the group – consisting of five students – finding 20 friends in the target market. They were able to send the survey to those friends. The response rates varied from about 30 percent to 70 percent. My goal was for them to send out 100 surveys and I was surprised by the high response rates.
The students surveyed their friends, which only makes sense for a business if you're trying to sell the startup's product to people in that demographic group. Otherwise, be sure that the 100 people you send the survey to are in your target market.
5. Apply rules of thumb and estimate the revenue.
Once you have the survey responses, use them to estimate the company's revenue. The response to the first question about likelihood of purchase will need adjustment. A rule of thumb I teach students to use is to multiply the number of respondents who say they will definitely use a service by 80 percent.
That's because people exaggerate when they answer surveys. So if 20 people said they would definitely use a service, assume that 16 will. Let's say that your respondents also indicated that they would buy your product once a month, purchasing one unit at a time on average and shelling out $10 a piece.
If you received 100 responses, say, and the target market was 100,000 students in the Boston area, then you might estimate your revenue at $1.92 million a year. How so? Assume that 16 percent of the 100,000 people in the target market would buy your product at that rate and price. (Thus 16,000 x 12 units a year x $10.)
This method of estimating sales will not be perfect. But by surveying consumers, you demonstrate to potential investors that you can talk to potential customers about your product and get their feedback on what it's worth to them.
And this process gives me more reassurance that you might have the skills needed to build your business.