Weekly Briefing Note for Founders 17/10/24

16th October 2024
CATEGORY:

The importance of Founder/Market Fit in fundraising

Early-stage investors say 'Founder/Market Fit' is a key indicator of startup success. According to an analysis by Forbes, this stems from the belief that founders who possess it have "an innate, unfair advantage that sets them apart from their competitors."

At early stage, when there is limited empirical data to go off, investors rely on founders to convince them that there is a market for their product and that they are the founders to make it happen.

So where does this founder insight come from?

Founder/Market fit - the source of this insight - is often correlated with industry experience. To underline this, Forbes identified 8 signs that a founder has strong Founder/Market fit:

  1. You have been working in your industry for several years
  2. You have a large network in your industry
  3. You have held different roles in your industry and understand the key players
  4. You have lived and breathed the problem you are solving firsthand and deeply understand the pain points
  5. You can speak fluently about your industry and the problem you are solving
  6. You understand the current and future competitive landscape of your industry
  7. You identify with your customer because you have either been your own customer or have conducted extensive research analysing your early cohorts
  8. You have become obsessed with the problem you are solving and have been relentless in learning everything about the market

But we know that many of the greatest startup success stories were built by founders with no industry experience. The founders of Microsoft, Facebook, Tesla, Google and Dell all created highly successful technology firms when they were in college. In other words: 'No experience necessary'.

So what is the right answer? To have strong Founder/Market Fit, when does experience count and when is an outsider's perspective a greater advantage?


Incremental vs Disruptive innovation

Research by US VC NGP Capital has thrown real light onto the 'experience' vs 'outsider' question. This analysis studied the founding teams of 1,747 companies that went public on U.S. exchanges from 2019 to 2021. The research focused on 162 founders and co-founders from 75 newly minted publicly held unicorns (exceeding $1 billion valuation) among venture-backed information technology companies.

On average, founders had 8 years of work experience when launching their startups. But one-third of the founders had no prior industry experience, and their companies represented nearly half of the $800 billion combined market value as of October 2022.

The analysis showed that prior experience varied widely among founding CEOs - seemingly benefiting founders in some cases and not in others. CEO experience was more consistent when startups were divided into two groups based on incremental and disruptive innovation.

In very simple terms, incremental means 'better'. Disruptive means 'different'.

Founders promoting incremental innovations were six years older and had over four times more industry experience on average than founders of startups promoting disruptive innovation.

In other words, the findings suggest that incremental innovation benefits from industry experience, while disruptive innovation tends to come from outsiders unencumbered by standard industry practice.

The big takeaway: Founder insight, not experience, was the shared trait among these successful startups:

NGP observed: "Founders consistently spoke of insights that drove them to launch their successful startups. Insights emerging from industry experience were a reliable guide for incremental innovation. Disruptive innovation emerged from founders outside the industry leveraging lead user insight or first principles thinking to identify overlooked opportunities or see known problems from a different perspective."

Footnote: Founder interviews revealed a further important observation regarding fundraising. Half the founding CEOs with little or no prior industry experience indicated they had difficulty raising early funding, while over three-quarters of experienced founders were more readily funded. This may be because Founder/Market Fit still correlates so strongly with industry experience, which is seen by investors a proxy for lower risk.


'Zero to One' vs 'One to N'

The NGP study also draws a fascinating comparison with Peter Thiel's earlier work captured in his groundbreaking book Zero to One. 'Zero to One' is associated with disruptive technology that creates brand new markets, while 'One to N' indicates incremental innovation that improves on existing solutions within current markets.

Top-tier VCs often say they are searching for the 'disruptors' or the 'pattern-breakers'. Founders that see a very different kind of future and act to create it. But incremental 'One to N' innovation can also produce significant outcomes. In practice this is where most venture investors play, even though they wouldn't always admit it!

Paul Asel at NGP says that the distinction between disruptive and incremental innovation helps resolve the conundrum of founder experience. "My research suggests that incremental innovation is empirically oriented and benefits from industry experience, while disruptive innovation involves first principles of thinking independent of experience." This was born out by the results.

Of the 75 unicorns:

  • 34 were 'Zero to One' companies. Here Founding CEOs were 28.5 years old
  • 41 were 'One to N' companies. Founding CEOs were on average 34.8 years old when they launched their startup

'One to N' founders were over six years older, had over 4x more industry experience (8.6 years v. 2 years), and over 2x more technology experience (11 years v. 4.3 years) than founders of 'Zero to One' companies.

And in terms of idea sourcing:

  • In Zero to One startups, 62% of founders had no prior industry experience. These outsiders were more likely to identify linkages from other industries, see overlooked gaps in the market, and reimagine businesses from a first principles perspective.
  • In One to N startups, over 80% of founding CEOs had prior industry experience, and most sourced their startup idea from this experience.


Insight is essential at every stage

As we noted above, founder insight, not experience, is the shared trait amongst successful startups. Insight can come from either experience or an outsider's unique vantage point.

But there is a balance (experience vs outside view) that shifts depending on the stage of the startup. Let's consider the 4 initial stages as:

  1. Problem/Solution thesis - is this a genuine problem worth solving?
  2. Product/Market fit - can we solve it for a large enough cohort of customers?
  3. Go to Market - can we grow and establish a well-defended market position?
  4. Business Model - can we make money at scale?

Problem/Solution Thesis - Having an Insight that the problem or opportunity exists and that we can create an innovative solution comes first. This is the most profound application of insight as without it, we can't even begin. The Problem/Solution Thesis is usually the defining insight of disruptive startups as it is the genesis of the founder's vision. It is also very important for incremental startups, but it is often more important to have this idea first so a time to market advantage can be secured.

Product/Market fit - We need product insight that enables us to solve the same problem for many customers. This is equally challenging for disruptive and incremental startups but in different ways. The disruptive startup begins from first principles in defining the product, whereas the incremental startup is more sensitive to what has gone before. Perhaps a co-existence strategy may be employed. In such cases we begin to see the value of industry experience.

Go to Market - As the startup engages with more customers, the growth plan must kick in.  For disruptive startups the GTM strategy may be just as innovative as the product itself. For example, opening up new markets with a product led growth (PLG) strategy may create immediate momentum. But incremental startups often have to play the game on the field. There may be well-established channels that must be used, and customer engagement protocols that must be adhered to.

Business Model - For disruptive startups there are no bounds for how to make money at scale. Again, the business model can be just as innovative as the product itself. But incremental startups will be under greater pressure to follow accepted norms. In established industries - especially those that are highly regulated - these norms will have been highly optimised over many years to favour the buyer.


Selling into highly regulated industries

All startups - whether incremental or disruptive - face huge challenges selling into highly regulated industries. For example, Aerospace, Automotive, Defence, BioTech and Public Health demands greater observation of established processes.

Such industries are typically less accepting of the fail-fast approach of the lean startup model. They will generally favour incremental over disruptive ideas. Formal product evaluation, often tied to technology readiness levels (TRL) is usually required, with the big corporates often unwilling to engage before TRL 6 (prototype). Procurement is often highly formalised and bureaucratic with (punitive and startup unfriendly) terms often being dictated by the buyer.

Venture investors are always more nervous about backing startups that target such established industries unless the founder has deep prior experience. Without this, it is unlikely the founder will have the insights required to design and negotiate a startup-friendly customer engagement. Here, an established network is often essential in helping the founder access the key players to make this happen.


The curse of too much knowledge

Respected US investor Nfobserves that a lot of nuance is required to properly evaluate how experience influences Founder/Market Fit.

Partner, James Currier, says that too much experience is not always a good thing. "Certainly, we do look for Founders who have enough industry experience that they understand the market. But not so much experience that they don’t have any disruption left in them. At some point, if you stay in a sector too long, you get the curse of too much knowledge, and you stop being able to see fresh or new ways of doing things. The angle for innovation becomes harder."

Currier then adds that the type of business you’re building matters. "Experience is more important in the B2B space, where the complexity of the industry raises the threshold of how much domain knowledge a Founder needs before they’re going to get it right. The more regulated and enterprise-facing the space is, the more you need a ton of experience and credibility to have a shot."

He says it’s skewed even further in healthcare and biotech, where closer to 80% of founding CEOs have directly relevant experience. Experience seems to matter the least in consumer.


In summary

  • Investors agree that 'Founder/Market Fit' is a key indicator of startup success, but this doesn't just come from experience.
  • Experience matters most in incremental startups. Outsiders are more likely to create disruptive startups.
  • Disruptive startups raise more money but are harder to fund.
  • Founder insight, not experience, is the shared trait amongst successful startups. But the source of this insight has different degrees of significance through the early stages.
  • Investors favour founder experience and domain knowledge when targeting established and regulated B2B sectors.
  • But too much experience is not always a good thing. It can become a counterweight to new and disruptive ideas.



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