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August 25, 2020

3 Questions You Should Ask Before You Invest

Note: The following is a guest article written by our friends at Early Investing. Early Investing helps readers find the most promising investment opportunities outside the stock market. They recently wrote about three key questions you should ask to understand a product’s potential for success. We thought it was a great read, so we’re sharing it with you.

The best startups make the world faster, safer, cheaper, more convenient, less dirty and more fun. Their innovative products meet old needs in new ways — or address new needs in any way they can.

Of course, a startup needs a lot more than just a good — or even great — product to become successful. Building a great product is not the same as building a great company. But it’s a lot harder to build a dominating company without a great product paving the way.

As investors, we need to understand a startup’s product so we can determine its potential for success. But that can be easier said than done. You can ask 100 questions about a product and still not fully understand how it works or how useful it is.

Fortunately, I’ve found a better way. There are three basic questions you need to ask to get a very good idea of a product’s risks and rewards…

1. Does it work?

It doesn’t get more basic than this. But this question often gets overlooked. Investors either assume the product works, or they take the founder’s word for it. That’s not good enough. If more than a dozen veteran venture capital investors had taken this question more seriously regarding Theranos, they would not have lost millions of dollars backing technology that didn’t do what the founder had promised.

If your research confirms that the product does indeed work, you’ve removed the biggest product-related risk. The one exception is pharmaceuticals. Instead of this being the first question, it should be the last with those startups. You only get a definite yes (or no) when the product’s clinical tests are finished.

This question is all about risk. It has nothing to do with upside or reward. That’s addressed in the next question.

2. Is the new product 3-10X better than previous solutions?

If the answer is yes, then that eliminates some of the investment risk. But that’s not why we ask this question. A product or technology that greatly outperforms other products can steal market share from them. If these other products enjoy massive adoption, the new and obviously superior product can rapidly ramp up revenue with even just a modest piece of market share… something, say, well short of 5%.

But making a product that’s 3-10X better is not easy. Think of what “three times better” means in practice. An hour-and-a-half flight takes just takes 30 minutes. Or you pay just $100 instead of $300 for that flight. Instead of eating peanuts during that flight, you’re served a steak dinner with a good glass of wine.

And that’s just 3X better. It’s easy to imagine how a product that’s 5X, 8X or 10X better could capture much more than 5% of a market. A product that is 3X-10X better and is scalable… belongs to a non-niche market… and has a pretty good team immediately makes the company a realistic unicorn candidate.

Asking the 3X-10X question is all about upside and reward. It’s not absolutely necessary. Growth can still be achieved through elite execution of branding and marketing. But it’s a great deal harder.

3. Is it 50X better? 

This question is tough because it can be hard to recognize what a 50X improvement looks like. Here’s a tip —  a product or technology that’s 50X better puts the industry it’s addressing on a completely different and (at first) unrecognizable level. Technologies that fundamentally reimagine and change an industry are rare. They have transformative and far-reaching impacts that often reverberate beyond the industry itself.

Transformative technologies and products threaten vested interests. They demand changes of hard-to-break consumer habits and culture. The infrastructure and ecosystem they need to thrive are often absent. There’s risk everywhere you turn.

But you also get super-sized rewards. With decent leadership, enough money to fund a long runway and lots of luck, unicorn status eventually becomes the floor. The ceiling is raised much higher than before. The risk may be high, but the reward is every bit as great.

A Pizza for Every Investor’s Taste

Let’s try these three questions on a startup whose products are pizza-making machines that use recipes provided by third party restaurants.

Does it work? The prototype pizza-maker seems to work. The pizza comes out hot and steaming. The crust is crispy but not burnt. No reason why it can’t be mass-produced. The company gets a resounding “yes” here.

Is it 3-10X better? The price is about the same. I haven’t tried one of their pizzas myself. But I’ve talked to several people who have. And they say the quality and taste is nearly as good as if the same pizza was made in the pizza joint or Italian restaurant where the recipe comes from.

What’s so special about this pizza-maker then? It’s smaller than a vending machine. And it can be placed anywhere there’s a bit of open space. In the lobby of an apartment or office building. In an airport or train station. Or in the corner of a store — like a 7-11 or CVS. And it can make a pizza in just three minutes.

Your favorite pizza restaurant can place a few of these machines a couple of miles from its location in all directions. One would probably be near you. You order online, pick up the pizza, bring it back home in as little as 10 minutes. I’d say the convenience of that is at least 3X better. It reminds me of when ATM machines proliferated. Instead of visiting your local bank to get or deposit cash, you could go to a nearby ATM machine and get cash in 60-to-90 seconds. Now, suppose if just one company made a decent ATM machine and you had a chance to invest in it at an early stage. That’s upside. And that’s the power of 3-10X better.

Is it 50X better? Unless eating a pizza a day from this machine will add 20 years to my life, I’d say probably not. I’d also say that ATM machines did not transform the banking business. It made banking for retail customers much more convenient. That was a big change for the better. But it didn’t upend banking in any other meaningful way. So no unicorn status as a floor here, but still a solid investment.

One more thing. This is not a hypothetical example. It’s a real company. And its pizza-making machine is amazing. It’s raising now on one of our favorite portals. I’ll be writing a report on it in the near future. The technology has a fascinating history, as does the founder. My report will look at that history as well as even more reasons why I think this startup has incredible upside.

About: Andy Gordon

View Andy Gordon's articles

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