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Screening Criteria: The Characteristics of High-Potential Ventures

Venture capitalists, savvy entrepreneurs, and investors also use this con­cept of boundaries in screening ventures. Exhibit 2.1 summarizes cri­teria used by venture capitalists to evaluate opportunities. Their criteria tend to have a high-technology bias. As will be seen later, venture cap­ital investors reject 60-70 percent of the new ventures presented to them very early in the review process, which focuses on how the entre­preneurs satisfy these criteria.

However, these criteria are not the exclusive domain of venture cap­italists. The criteria are based on plain good business sense that is also used by successful entrepreneurs, private investors, and growth-oriented small businesses. Consider the following examples of great small com­panies built without a dime of professional venture capital.

Paul Tobin, who built Cellular One in eastern Massachusetts from the ground up to $100 million in revenue in five years, started Roamer Plus with less than $300,000 of internally generated funds from other ventures. Within two years, it grew to a $15 million annual sales rate and was very profitable.

Mark Nelson started Ovid Technologies in the late 1980s in a one-bedroom apartment in Manhattan's Spanish Harlem. Unable to find investors, he grew his company by renting more and more apart­ments in his building until computer network wires ran in and out of windows. Salaries for his employees were low, but at least Nelson allowed them to live rent-free in their office spaces! It was not until 1994, when Ovid had 150 employees, that he went public and raised $10 million. In 1999 he sold his company for $200 million.3

• In 1986 Pleasant Rowland founded the Pleasant Company mail-order catalog company as a means to distribute her line of American Girls Collection historical dolls. She had begun the company with the modest royalties she received from writing children's books and did not have enough capital to compete in stores with the likes of Mat­tel's Barbie.4 By 1992 she had grown the company to $65 million in sales. Mattel acquired it in 1998 for $700 million, and under her con­tinued management the company had sales of $300 million in 1999 and 2000.5

The point of departure here is opportunity and, implicitly, the cus­tomer, the marketplace, and the industry. Exhibit 2.2 shows how higher and lower potential opportunities can be placed along a desirability scale. The criteria provide some quantitative ways in which an entre­preneur can make judgments about issues concerning industry and mar­ket, competitive advantage, economics and harvesting, management team, and fatal flaw - and whether these add up to a compelling oppor­tunity. For example, dominant strength in any one of these criteria can readily translate into a winning entry, whereas a flaw in a single one can be fatal.

As a small business entrepreneur, you are in a better position to decide how these criteria can be compromised. As outlined in Exhibit 2.2, businesses with the greatest potential will possess many of the fol­lowing criteria, or they will dominate in one or a few for which the com­petition cannot come close.

Industry and Market Issues

Market. Higher potential businesses identify a market niche for a prod­uct or service that meets an important customer need and provides high value-added or value-created benefits to customers. Customers who are loyal to your brand or with no brand or other loyalties are reachable and receptive to the product or service (thus giving you the opportunity to seize customer loyalty). The potential payback to the user or customer of a given product or service through cost savings or other value-added or valued-created properties is one year or less and is identifiable, repeatable, and verifiable. Further, the life of the product or service exists beyond the time needed to recover the investment, plus a profit. And the company is able to expand beyond one product. If benefits to customers cannot be calculated in such dollar terms, then the market potential is far more difficult and risky to ascertain.

Lower potential opportunities are unfocused regarding customer need, and customers are unreachable and/or have brand or other loyalties to competitors. A payback to the user of more than three years and low value-added or value-created properties also makes a company unattrac­tive. Being unable to expand beyond a one-product company can make for a lower potential opportunity. The failure of one of the first portable computer companies, Osborne Computer, is a prime example of this.

Market Structure. Market structure, such as that evidenced by the number of sellers, their size distribution, whether products are differ­entiated, conditions of entry and exit, number of buyers, cost condi­tions, and sensitivity of demand to changes in price, is significant.

A fragmented, imperfect market or emerging industry often contains vacuums and asymmetries that create unfilled market niches - for exam­ple, markets where resource ownership, cost advantages, and the like can be achieved. In addition, there are opportunities where information or knowledge gaps exist and where competition is profitable, but not so strong as to be overwhelming.

Highly concentrated and perfectly competitive industries or those that are mature or declining are typically less rewarding. The capital requirements and costs to achieve distribution and marketing presence can be prohibitive, and such behavior as price-cutting and other com­petitive strategies in highly concentrated markets can be a significant barrier to entry. (The most blatant example is organized crime and its life-threatening actions when territories are invaded.) Yet revenge by normal competitors, who are well positioned through product strategy, legal tactics, and the like, also can be punishing to the pocketbook.

The difficulty of operating in perfectly competitive industries is cap­tured by this comment by prominent Boston venture capitalist William Egan: "I want to be in a nonaucrion market."6

Market Size. Companies that sell to large and growing markets (i.e., ones where capturing a small market share can represent significant and increasing sales volume) can themselves grow rapidly A minimum mar- ket size of over $ 100 million in sales appears to be the threshold size to foster such growth. Such a market size means it is possible to achieve sig­nificant sales by capturing roughly 5 percent market share and thus not threatening competitors. For example, to achieve a sales level of $ 1 mil­lion in a $ 100 million market requires only 1 percent of the market. Once the small company achieves a foothold, then the foundation is in place to grow. If you are in a substantial market with 5 percent market share, then you may have an opportunity to scale into a high-value venture.

However, such a market can be too large. Amultibillion-dollar mar­ket may be too mature and stable, and such a level of certainty can translate into competition from Fortune 500 firms and, if highly com­petitive, into lower margins and profitability An unknown market or one that is less than $10 million in sales also presents obstacles to growth. To understand the disadvantages of a large, more mature mar­ket, consider the entry of a firm into the microcomputer industry today versus the entry of Apple Computer into that market in 1975.

Growth Rate. It is easier to capture new business from a large and growing market than it is to take business from others in a stable or declining market. An annual growth rate of 20-30 percent expands niches and indicates a market is a thriving and expansive one rather than a stable or contracting one, where competitors are scrambling for the same niches. Thus, for example, a $100 million market growing at 50 percent per year has the potential to become a $1 billion industry in a few years, affording the company with a foothold to grow substantially if it just maintains its market share over the next few years.

Market Capacity. Another signal of the existence of an opportunity in a market is a market at full capacity in a growth situation - in other words, a demand that the existing suppliers cannot meet. A growing industry where other manufacturers are at full capacity is an exciting environment. Timing is of vital concern in such a situation, which means the entrepreneur should be asking: Can I fill that demand before the other players decide to and then actually increase capacity?

Market Share Attainable. The desire and potential to be a leader in the market and capture at least a 20 percent share of the market is important and can create a very high value for a company that might otherwise be worth not much more than book value. For example, Key­stone Automotive Operations, Inc., started as a supplier to hot rod builders and racers. They expanded the business in response to the explosion of SUVs in the 1990s. In 2003 the company was the nation's largest warehouse distributor of specialty parts for autos, SUVs, and light trucks.

Cost Structure. In general, firms with lower costs are more profitable; however, industries that continually face declining cost conditions place margin constraints on all participants. Interestingly, certain small firms might have great expansion potential because of low costs learned over many years. We have seen many low cost competitors that didn't real­ize the real value of their long experience. Where costs per unit are high when small amounts of the product are sold, existing firms that have low promotion costs can face attractive market opportunities. For instance, consider the operating leverage of Johnsonville Sausage, a manufacturing company in Wisconsin. Their variable costs were 4 per­cent labor and 58 percent raw materials with the remaining going to overhead, sales and marketing, and profit. What aggressive incentives could management put in place for the 4 percent to manage and to con­trol the other costs? Imagine the disasters that would occur if the sce­nario were reversed!

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