Entrepreneurs can pursue an opportunity much as scientists pursue knowledge–by following a disciplined process of identifying an anomaly in the market, formulating a plan to fill the gap, testing their plan in the real world, and revising their assumptions in light of new information. Menlo Park based ONSET Ventures, a venture capital firm focused on fledgling start-ups, has codified a set of practices that increase the odds that entrepreneurs formulate, test, and revise their working hypothesis in a disciplined fashion.
Since its founding in 1984, ONSET has backed over 100 early stage start-ups, 80% of which have gone on to receive subsequent rounds of financing, a much higher success rate than the average for investments in raw start-ups. When they co-founded ONSET in 1984, Terry Opdendyk and David Kelley (who also founded IDEO) conducted a systematic study of 300 seed stage ventures, with an eye to understanding the factors that influenced their ultimate success or failure. They found that a few factors accounted for most of the variation between successful and failed start-ups, and codified these findings into a set of principles for incubating new ventures.
- Simplify the working hypothesis. When selecting potential investments, ONSET partners use a set of simple rules to screen out those opportunities that will require more than $30 million total investment (thereby depressing returns), that attack an entrenched market leader, stray from industries ONSET knows, or target small markets. By following these heuristics, ONSET partners minimize the number of variables they must worry about, and focus on the market need, product, and business model. Reducing the dimensions simplifies the task of formulating and re-evaluating the working hypothesis as they move through successive rounds of experimentation in the market place.
- Change the business model. In their initial research, ONSET’s co-founders discovered start-ups that were still following their initial business model twelve months after foundation, failed nine times out of ten. Failure occurred because founders and investors locked into a working hypothesis too early, and refused to revise their assumptions in light of new information from market experiments. ONSET follows a principle that the firm will not seek further funding until a portfolio firm’s business model had changed at least once. According to Opdendyk, multiple revisions are more typical.
- Work with entrepreneurs who want to be rich not king. ONSET partners explicitly seek entrepreneurs who are willing to sacrifice some control over the venture’s evolution in order to create economic value. They ask entrepreneurs if they would rather be rich or king/queen. Founders who cling tightly to control are less likely to rethink “their” business model, whereas those focused on value creation are more likely to adapt their working hypothesis in light of new information.
- Don’t hire a CEO until the business model is stabilized. ONSET’s founders discovered that start-ups enjoyed a much higher likelihood of success if they delayed committing resources until the business model had stabilized. They will not, for example, hire a CEO or other key managers for until initial iterations of hypothesis, experimentation and revision produce a stable business model. If they hired top executives before the business model has stabilized, ONSET runs the risk that the incoming CEO would come in “knowing the answer” and fail to revise the working hypothesis as experiments warranted.
- Bring in outsiders to evaluate the working hypothesis. To maintain objectivity when evaluating their portfolio companies, ONSET partners invite venture capitalists (who might invest in the start-up in later rounds of funding) to evaluate the business plan. In this process, which ONSET calls “projection and reflection,” the partners specifically ask outside investors what accomplishments-such as launching prototype of the product or validating market size–would increase the valuation of the business in subsequent rounds. The later-stage venture capitalists, completely uncommitted to the venture at that stage, can objectively evaluate the working hypothesis.
Entrepreneurs and venture capitalists are not the only people who pursue new opportunities, so to do managers within established corporations. My next post introduces a set of criteria for designing entrepreneurial experiments that can be used in many different settings.