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Monday, August 1, 2016

Inflection Points and Hockey Sticks

The term "Inflection Point" is used repeatedly during startup pitches, and is one of those overused terms you grow a little sick of when you have to deal with that world, in part since it is rarely used to describe an actual inflection point. So what is it? 

In mathematics it's the point at which the curvature of a curve changes direction, like below:

But since we're talking about investing and startups, what's usually meant is that it is a moment of dramatic change, a sudden upturn (or downturn) in sales or growth. (Obviously, when business use the term they rarely want it associated with a downturn, but it is equally applicable!) It's pretty obvious where the inflection point in the below image is, and tends to be more of the business meaning.

When you're doing a pitch-deck in fundraising, you have to come to your predicted sales graph, and if you want funding, it better be a "hockey stick" - that is, flat for a few years, then around year 3 to 4 starts to uptick significantly, then leaps hugely in year 5. Without that, you get no funding. So pretty much every pitch deck for a startup shows a loss in year 1, a smaller loss in year 2, breakeven in year 3, modest profit in year 4, and $10 billion of revenue in year 5. Small exaggeration, but not much. Here's WeWork's numbers, with which they raised a substantial amount of money, nearly $1.5 billion

As an example of how this can play out, in a former life I was pitching for funds for a company that was developing software for retail. Creating a business plan, I thought that conservatively we could be at around $25 million a year in revenue by year 5, and as we were asking for $250k to $500k from angels, it seemed reasonable. Of all the slides in the deck, I got grilled on that on in pitches more than any other, and was flat out told that the company wouldn't grow big enough for it to be of interest. So I reran the numbers, changed some assumptions to be more positive, and pitched at $40m by year 5. Same result, and detailed questions on that slide, and disbelief.

At this point I really was struggling, as I simply couldn't justify moving much past that $40m number (which, for those of you who don't do this kind of thing, is a pretty damn good number to get a return for a ~$500k investment). Without money, we were going to have to stop work, but how to get it without plain lying?

My solution was this - I still showed the "$40m by Year 5" slide, but then had a second chart with the caveat "If extended to multiple verticals" and the numbers reached $150m a year by Year 5, and then made no claims as to the chance of achieving that. This was ridiculous, it was never going to happen, but here was the interesting thing - as soon as I did that, not a single question on the financials, we just moved smoothly on. It was amazing.

Finally, I asked one of the potential investors why he hadn't questioned me on that slide as it was clearly never going to happen and his answer was this:

It's not your role to decide to be conservative for me or to decide my risk. I decide that. You show me as good as it can get, I'll factor in my acceptance for risk. Investors expect to see curves like that, just show them.

So there you go - if you wonder why the funding goes to the charlatans that are prepared to lie or make outrageous claims it's because the people with money demand that you do. If you don't they think there's something wrong with you.

And if you wonder why startup CEOs use "inflection point" for things it's not even vaguely appropriate, it's because saying it got them millions in funding, so they just keep using it on everything else as it must be a Harry Potter-esque phrase of magic power.

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