I have been thinking of doing my own startup for a while now. When I ask established entrepreneurs about what kind of startup idea I should pursue, I get advice ranging from - "Just jump in with something, and you will pivot your way to the right idea" to "Jump only when you have some traction with initial customers". And of course the timeless gem "scratch your own itch". Predictably, I have chosen the middle path, where the idea or the market has some hope of success, but I don't have to wait to set up the business and get traction before I quit my day-job. In fact, I have come to the realization, that I'll not be able to give my startup enough attention to get traction while still holding a day-job. In this blog post I'll talk about the three evaluation criteria I use when deciding whether or not to pursue an idea -

  • Will the business be scalable?
  • Does it have network effects?
  • Does it have either high margins or high volume?

Will the business be scalable?

A very simple way to answer this question is to understand what it takes to sign up one new additional customer for the business. Take a traditional dentist for example. In order to sign up a new patient (a.k.a customer) the dentist will have to spend as much amount of time on the new patient as he does on his existing patients. In economic terms, the marginal cost of servicing a new customer is pretty high. Moreover, there are only so many patients the dentist can see in a day. Which means there is a physical cap on the number of customers in this business. This is not a scalable business. Contrast this with a dentist selling "do-it-yourself dental checkup" kits. The cost of establishing the business would be pretty high. But selling each additional unit will be small in comparison. Moreover, there is no physical limit to the number of customers that can be served. This is a scalable business. Needless to say, in most cases going after a scalable business is better than going after a non-scalable business.

Does it have network effects?

Network effects are what help businesses go viral. Network effects means that every new person who uses the service makes it more valuable for all other users. Take the telephone for instance. If only 2 people in a town have telephone it is marginally useful for them. But when a third and then a fourth person get a telephone, the value of the telephone increases for all 4 people. A more cotemporary example would be facebook where, as more and more people signed up, it became more and more valuable to its existing users, in turn causing more and more people to sign up. Apart from promoting viral growth, network effects also help build high barriers of entry and increase switching costs for its users. Think again about moving your entire social network from facebook to google+. Not gonna happen...at least not very easily. Network effects are often found in multi-sided markets. For example game consoles like XBox have multi-sided networked markets with game players and game providers. More the number of players, more game companies build games for the XBox platform. More games available will attract more players and so on.

Does it have either high margins or high volume?

Making high profit per unit sold is a good thing. In the online services world, this would translate to average profit per user. If this is high then it is ok to have less number of users. Good examples are enterprise software companies like SAP or Oracle. Their high margins enable them to serve only the top Fortune thousand companies. However, companies like Amazon Web Services have shown us that having a low margin (rumored to be < 5%) per user but having a high volume of users is just as profitable. Obviously a business that has potential for neither high margins nor high volume is not attractive. And one that has both is super attractive!

Not all startup ideas have to have all three characteristics. Some good startup idea may not have any of these. But in general, asking these questions gives me a good idea of the potential of the startup.