Bottom Line: Predicting a startup’s success before the venture is even launched may seem impossible. But entrepreneurs and investors should never overlook the value of assessing the basic concept behind the business.
You only have to watch an episode of Shark Tank to realize that turning the glimmer of an idea into a viable business entity is no easy feat. Many researchers attribute a startup’s fortunes to its founder’s ability to attract funding, lure essential employees, and deploy initially limited resources to pursue a strong but sustainable rate of growth. Venture capitalists essentially use the same metrics when they peer through the fog of uncertainty and weigh whether a fledgling project deserves their investment — and if so, for how long.
But perhaps, the authors of a new paper suggest, the success or collapse of a new venture can be predicted by evaluating the fundamental idea behind the business, long before an entrepreneur secures first-round financing or signs the lease on that first office space. Maybe the commercial viability of a new business hinges less on the founder’s personality, experience, and relationships with angel investors, the authors posit, and more on the simpler metric of whether the idea is good.
Few empirical studies have been done on whether the commercial feasibility of an idea is linked to a startup’s early-stage results or the long-range funding it may receive. It’s difficult to obtain projections from a firm’s embryonic phase that aren’t tainted by hindsight or tied to the amount of investment and resources plowed into the concept around the time of its inception. After all, when an early-phase investor does like an idea, he or she tends to put money into it, meaning evaluations usually can’t be untangled from the financing and resources a young company receives. Entrepreneurs may also be more or less likely to further fund or expand their ventures on the basis of investor feedback, effectively turning their initial interactions with financial backers into self-fulfilling prophecies.
To get around this problem and focus on the importance of the basic business idea, the authors exploited a unique database: the Massachusetts Institute of Technology’s Venture Mentoring Service (VMS), which seeks to help entrepreneurs develop their early-stage business concepts. The authors gathered data on the characteristics, evaluations, and eventual outcomes of 652 ventures that made use of the VMS between 2005 and 2012. Most of the projects — which ultimately raked in more than US$700 million in venture financing — targeted competitive sectors typified by high levels of entrepreneurship, such as manufacturing, software, and medical devices.
When an entrepreneur joins the VMS, a select group of more than 100 analysts, executives, and investors with extensive experience in consulting early-stage businesses receive a summary, prepared by VMS staff, that outlines the proposed venture. The summary lays out the projected business model, technology requirements, key customer base, and obstacles to implementation. However, the startups’ summaries, which are uniform in tone and form, provide minimal information about the founding team and its credentials
Armed only with this summary, and without meeting the entrepreneurs, VMS advisors have to decide whether to work with a venture — the vast majority of which are unfunded and unincorporated at this point. It’s hard to get an advisor’s approval: On average, mentors express interest in fewer than 5 percent of the proposals they review. If a high number of mentors want to advise a given project, therefore, it provides a strong signal of the perceived quality of the business idea during its earliest incarnation.
The VMS concentrates on serious endeavors, not pie-in-the-sky fantasies. In the sample taken by the authors for their study, 46.5 percent of ventures got off the ground. Of those, 18.6 percent received backing from professional investors, and 22.4 percent eventually reached the dreamed-of commercialization phase, generating revenue from the ongoing sale of their products or services.
Concepts that generated a higher level of mentor enthusiasm were far more likely to get to that phase. Even a small uptick in the proportion of mentors attracted to a venture resulted in an average 17 percent hike in the likelihood that the startup would ultimately be commercialized, the authors calculated.
But the effect fluctuated greatly across industries. Mentor interest was much more strongly linked to eventual commercialization in sectors heavily dependent on R&D efforts — such as the energy, hardware, and science industries — and to startups whose business ideas were based on documented academic research or the possession of intellectual property. Ventures in R&D-intensive industries that received higher levels of initial advisor backing also raised significantly more funding.
Researchers have noted that business concepts can morph in dramatic ways during a startup’s initial phase. As a result, many investors hesitate to judge a proposal too early, and prefer to have some tangible evidence in hand before opening their checkbook. Indeed, the mentors in the study conducted their evaluations far earlier and with much less data than the typical professional investor, who seeks to generate as much information as possible before pledging support. And yet, based solely on a business proposition, these experts were far more likely to attach themselves to projects that eventually came to market than to those that ran aground.
Business concepts can morph in dramatic ways during a startup’s initial phase.
These findings are especially relevant in a time when young companies increasingly turn to seed funds, accelerators, and even online fundraising platforms to get their start. These financial intermediaries operate below the level of venture capitalists and allow entrepreneurs to modify their ideas at an earlier stage, albeit with less financing. Tapping into expert advice from diverse sources at the earliest opportunity could be the best way for entrepreneurs to solidify their business plan — and to encourage investors to place their bets.
Source: “Are ‘Better’ Ideas More Likely to Succeed? An Empirical Analysis of Startup Evaluation,” by Erin L. Scott (National University of Singapore), Pian Shu (Harvard University), and Roman M. Lubynsky (Massachusetts Institute of Technology), Oct. 2015, Harvard Business School Technology & Operations Management Unit Working Paper No. 16-013