(I’m on a family vacation this week so putting energy into other important endeavors 😉. This is the first ever issue of “Why We Passed on this Startup” that was released before I started writing on Substack. So, the vast majority of subscribers have not seen this. Hope you enjoy it now 😀)

-Matthew

I'm introducing a new newsletter series called “Why We Passed on This Startup.”

Most of the time, on LinkedIn or on your social media channel of choice, you see posts from investors such as,

“Why We Invested in XYZ Company…”

OR

“Excited to announce ABC Company’s Series B! The company is X and Y and represent Z…”

All this content is touting WHY they invested in such and a company.

That’s cool and it’s does a nice job of calling out the win (I do myself), but for founders, there are very little learnings from such a production.

When I was a founder, I got really agitated at this victorious processional. I thought to myself, “That’s great, but I have no idea what you saw in them and why I am any different?!”

The hype posts from investors made me mad, actually!

That’s why I am kicking off a periodic series that I call, “Why We Passed on This Startup,” to get to the underbelly of WHY I and Tundra Angels decided to pass on a startup - either in conversation before the pitch meeting, or a pass decision after the startup pitched to the Tundra Angels group, or after due diligence post-pitch meeting.

This series intends to provide an inside look into how I as an investor make decisions and reveal why we might invest in a startup, and why we did not.

The ultimate aim is to help founders be empowered with the delta on what may be missing from their respective companies as they look to build product, acquire customers, fundraise, build defensibility, and win in the market.

In every episode, I will anonymize the stories but leave most of the details so that founders can learn from it all. So here we go…

Once upon a time, I met a startup team that had a groundbreaking technology for the sector. Truly, it represented and still represents the future of a particular use case and an industry as a whole.

I liked the startup and the Tundra Angels investors really liked the startup as well. For example, here is text from an email that I sent to the Tundra Angels group at one point:

“For context, this company pitched in ________ meeting and gained heavy interest from our group. Our group ended up assembling a 5-6 member due diligence team that put together a robust due diligence memo for all of our investors. Concurrent to that, I put them in touch with ______________ investors that could make sense to lead their round. The consensus from the ones that looked deeply was "interesting technology but too early (i.e. not enough market traction)." In our group, I ended up giving the team the answer, "Get market traction/pilots and come back." 

Now, they have pilot agreements with three _(industry players)______ as well as enthusiastic champions that could be leveraged for us to validate the customer need in due diligence. Importantly, they have also sharpened their use case of the technology….. Sharpening that use case brings a much better level of clarity to the technology and opportunity.”

For context, the founders were executives in their industry. The startup had validated that the technology worked in a certain context, and was raising funds to build their production-ready product that could implement in their context.

Traction-wise, the startup had acquired three highly reputable pilot sites in the industry that they were in. One of the company names in particular was known nationwide with a reputation of integrating up and coming technology in the organization’s process.

The startup also had robust IP relating to the method that their technology took to accomplish the outcome.

The breakthrough was undoubtedly clear. Where things started to get not-so-clear was after the pitch in several discoveries in due diligence.

The founders had came from industry but were new to the venture backed fundraising world. As such, the valuations of earlier rounds (1.5 years ago) and this round were essentially at the same valuation. However, the company had made meaningful de-risking progress from a technical and a market standpoint. So why wasn’t the company raising at a higher valuation?

I decided to pose this question to one of our group members:

“Question for you - __________ have communicated that their valuation for this round is _(deleted)____. Extremely good price for such an early stage deal. 

It's at the same pricing as it was before in a __________ round. Per _(the CEO)____ in the email to me ‘"The round is valued at _________ post money. This value aligns with our earlier _______ round in ________ of this year, and reflects the value of the advances since then in customer use case, _________, pilot site identification, __________ etc.’"

I continued on in my question to the group member:

“If [the above] is the case, then the _(investment ask)____ is for around 25% of the company. I'm questioning as to why it's so low. Perhaps it’s due to the lack of experience in VC fundraising.

In theory this valuation should be higher than the last ________ round but it's not. There is no reason not to be. My biggest concern is that they sell themselves too short and we invest and we invest in this valuation because it's a sweet deal and there isn't enough equity pickup in later rounds to go around. I am really thinking the valuation should be higher, what are your thoughts?”

Then, our investor responded with:

“I can see that there might be “negative signal” by raising from angels at this lower valuation and VCs end up not participating because they are worrried that it’s a value trap.

Are you worried that there are fundraising dynamics in the future that make it difficult for the company to secure capital necessary to get cash flow positive and therefore sustainable? If yes, then a broader discussion around capital need to get to sustainability and “signaling” the market becomes important.”

This exchange resulted in a conversation that I had with the founding team around fundraising and fundraising dynamics. I raised the concern with the team and didn’t get clear answers as to why this round was not at a higher valuation.

✅ As I looked at the cap table, my ultimate concern was would this company have enough equity at a Series A round to make those investors interested? It seemed like they were heading for a situation where they would give up too much equity too early on. Thus, make it very hard for them to raise additional rounds of capital in a clean way. The ultimate risk was that if the company was headed for a re-capitalization, then there is no telling where an early angel investor like Tundra Angels would end up percentage-wise if a later stage VC got their tentacles all over the cap table and made sure they made investing worth their while. ✅

One the common steps of our due diligence process is to speak with current or prospective customers of the startup. Typically I prefer to speak with three, sometimes I speak with one. In this case, the startup gave me a connection to one. Given the circumstances they shared around the pilot, I was fine with it.

For context, keep in mind that the product was not quite in use yet.

I had a conversation with one of the potential customers at the pilot sites and discovered something interesting.

The founding team had positioned this pilot customer as a true believer in the startup’s vision and a real champion of the technology and the potential future it would herald.

When I got on the phone, I discovered that the “enthusiastic champion” that I referenced in my email to the Tundra Angel investors was not quite the champion that we thought.

Through conversation, it became apparent that this pilot customer had agreed to use the product to play a part in the future of his industry. Clearly a technology enthusiast.

But one comment summed up his perspective for me. It was when the person said to me, “So can this technology save time and help me ____________, uhh maybe?”

Maybe? This person is not confident in the value-add? This was a signal to me.

✅ I discovered that the pilot user was not piloting for value-based reasons. They were piloting for self-serving reasons, being a part of a bigger vision of what they thought could be the future of an industry. ✅

Conclusion: Their pilot customer didn’t have much skin in the game to stick with it and become a paying customer. Not a great signal, especially since the first users ought to become paying customers or the likelihood of progress diminishes.

After this conversation, as we thought about the market more, we took a step back and understood the levels of problem awareness the problem that this startup was solving.

For reference, here are the five levels of problem awareness courtesy of Justin Welsh.

As we talked to the founding team and I inferred in my conversation with the pilot customer, the market was in the problem unaware stage. The problem that was being solved for the user was not a top of mind problem for them. The problem was like wallpaper in a room - all of the end users in the market had been accustomed to the current workflow.

Because they were unaware, they were also unaware of what solving that problem would mean for them from a value perspective. I.e. - How much time would they save? How much more money would they make? Etc.

✅ Customers who are in the “problem aware” stage tend to already have done that mental and emotional calculation of how much this friction is costing them, which makes them more desperate for a solution. ✅

The fact that the market was in the problem unaware stage signaled that the Go-To-Market strategy would require a lot of education, not closing. That’s not a bad thing, but it’s also a much slower path to convert customers and gain revenue, thus requiring more capital over the long term for the company.

Lastly, the product design and experience inferred a high amount of change in behavior. Even the production-ready product as described by the founding team would involved the user to undertake several steps that is completely non-existent in their current workflow.

✅ Workflows, at their core, are path to achieve an outcome. The more hurdles on that process, the less likely the user becomes to go through the loop and get to the "a ha” moment.

There are workflows that are reductive to the friction of the existing process and ones that are additive to the friction of the existing process.

Workflows that win tend to be either highly reductive, friction-neutral, or slightly friction additive only the payoff is significant. ✅

The newly-proposed steps would be additive to the friction and be awkwardly weird for the user.

For the given use case of the user, time efficiency is important.

Thus, the proposal of, “Take time to perform extra steps when you are already under a time crunch” wasn’t a great proposal that seemed like it held significant weight.

I want to take a brief pause to contrast this encumbered workflow with the product workflow of another startup that I spoke to at one time, Atrility Medical. This is a case where the addition of their product, the Atriamp, is largely friction-neutral for the user's workflow. 

The Atriamp is a device that displays a post-surgery patient's atrial signal on the bedside monitor after they just had a heart surgery.

For the physician, the workflow inputs are the same:

But after that, the workflow output is even the same:

The physician looks at the bedside monitor, as he or she did before, and instead of NOT seeing the atrial signal, they now do see it! (no behavior change but astounding value)

Atrility Medical’s Atriamp is a major payoff for one quick minor step. The power of not changing the behavior and workflow is real.

For all of these reasons taken together, we made the hard decision to pass on this startup.

✅ Notice that it’s rarely just ONE factor - it’s how multiple variables add up to be greater than just a sum of its parts. ✅

Looking forward to additional episodes of “Why We Passed on This Startup” 🙌