Proof of Concept

1981: “No one will need more than 637KB of memory for a personal computer. 640KB ought to be enough for anybody.” 
— Bill Gates, co-founder and chairman of Microsoft.

What Marcelo Bravo proposes in the previous clip is the heart of the matter. In reality what you need to get investor’s money up front is a proof of concept. If you can approach any market or investor with a proven concept you have it made.

As George Deep puts it: I have had the luxury of meeting over 500 startups at red Rock Ventures over the last three years. And, typically, most of them approach me at the same point in their startup development. They have just finished building their new product, whether it be a website or mobile app or whatever, and they are seeking venture capital to assist them with sales and marketing to bring in new users. It is typically then, when I ask them “do you have any current users and how quickly are you growing” to point to a proof-of-concept around your startup. Which is typically followed by, “I don’t have a material user base yet, that is why I need the venture capital”. Then I shrug, and have to be the “bad guy” of telling them they are not ready to raise professional venture capital. A sad and familiar story, as without this round of capital, the startup will most likely go out of business, as they lack other sources. But, why is this the same old story? In my opinion, it is because entrepreneurs are so focused on their product, with their heads down coding away on some cool technology feature or functionality, that they don’t think far enough ahead to what will keep their business funded. Yes, many product-driven disciples will say, “if you build a great product, users will come”. And, they are right. But, the question is: by when?

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“Proof of Concept” is different to “Prototype.” A Proof of Concept (POC) is a small exercise to test the design idea or assumption with stakeholders who will be involved in the sales process. This means customers have tested the product, distributors have aligned it to their system, and engineers have given the thumbs up to scalability.

The main purpose of developing a POC is to demonstrate the functionality and to verify a certain concept or theory that can be achieved in development. Prototyping is a valuable exercise that allows the innovator to visualize how the product will function, it is a working interactive model of the end product that gives an idea of the design, navigation and layout, but it is only part of the POC. While a POC shows that a product or feature can be developed and marketed successfully, a prototype shows how it will be developed.

It’s hard to place a value on an idea when there’s no evidence to support that value, no matter how great you think the idea is. You might be convinced that you will turn it into a billion dollars one day, but the investor sees nothing but hope and empty words. As much as she wants to invest someone’s hard-earned money (it is often not the investor’s money) in your idea, how can she without knowing that there are sales or customers lined up waiting, or without knowing that the idea is workable?

What works very well to provide that evidence is to run a proof of concept. This means starting smaller and investing your own money, heart, and effort in a model or scaled-back version of the concept. If you can show that customers respond to the idea on a small scale, then investors are better able to envisage how the business will respond to an injection of capital and you’re more likely to get the capital you need.

You need something to convince your investors of your idea’s soundness. A proof of concept works best.

This is what I did with my first company. I had what I thought was a winning idea, and I had incorporated it as TGB International LLC. After several weeks of contemplating the incorporation paperwork, drawing diagrams on napkins, and then interviewing potential customers, manufacturers, and marketers I had fleshed out my first business plan.

I targeted an asset that I felt I could use my smarts to expand sales and raise profits. The asset I wanted to buy generated less than $700,000 a year in sales and was not very profitable, so I felt I could get it for a low multiple on revenue. I offered three times annual revenue in cash for the rights purchase, which was a fair market price for such a deal at that time. The challenge was that I had only $30,000 in savings and I needed $2.1 million

The owner of the asset was a distressed company suffering cash-flow issues (I read their SEC reports and reviewed chat online about the share price) The $2.1 million cash I offered was attractive. They asked for proof of funds. I set about finding an investor.

Banks gave me little encouragement. They struggled with the fact that the business model I proposed had never been tried before. They said that I had never been a CEO, or owned a company, and they simply did not know me well enough to take a leap of faith.

I had no rich relatives to beg from and few assets of my own to sell or leverage.

I met several venture firms. They were polite with their rejections. They got the business model and thought it all reasonable risk. However, it was clear that I needed to prove my concept somehow.

I knew of another asset that generated only $20,000 a year in revenue, made a loss, and that I could purchase for about one-times revenue. The owner would be glad to get rid of it and probably thought me a fool for buying.

I adjusted my business plan and worked out that I needed an additional $30,000 working capital to execute a market plan. If I could demonstrate to the VCs some improvement in this worn-out asset it would demonstrate the validity of my business model.

When the sale of our home closed I had sufficient funds to buy the asset and fund the proof of concept.

Although it was a product with only a small revenue stream, I was able to build the business model around it and within a few months show increased revenue and profit.

I lined up contract manufacturers, contract distributors, and then demonstrated the effectiveness of the marketing plan by creating a handful of new customers. I also set up outsourced accounting, regulatory, and customer services to showcase the virtual model in its entire hub and spokes structure. In effect I built a full, real company around this small asset and my pitch to the same VCs was along the lines of “I have set up a plug and play business. See what I did with this worn-out asset. Imagine what I can do with the bigger one.”

Investors could better envisage how a larger scale business would work. I got the funding. I bought the asset and QOL Medical was born. Without the Proof of Concept I don’t think it would have existed at all.

I come across a lot of companies that have spent all their own cash to develop a product, and have nothing left to test it in a POC. They often know that the next step is to give the product away for free and collect data on the benefit to the customer testing it, but they do not have the cashflow to buy the time to sit back and wait. It is essential, therefore, to build the proof of concept into the business plan process, and to have enough capital to see the business through the POC phase.

Example of POC

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In these days of “freemium” marketing (try it for free for 30 days etc) proof of concept is essential, especially for raising money. If you have experience of how the proof of concept helped raise capital or how a lack of POC and customer benefit data hindered raising money please share.

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