Friday, November 2, 2012

Tips for EdTech Entrepreneurs - Navigating This Mess

For many edtech entrepreneurs, their first angel or venture pitches are pretty nerve-wracking.  Here's a chart I will put up to characterize the thoughts of investors who actually want to make money in the K12 space.

The graph above is how I have always thought about startups.  You start in the lower left corner and you have to find your way to the upper right.  During that time, you are plotting a course between focusing on customer growth and revenue growth.  Traditionally, if you are an enterprise company (selling to businesses), you would try to go to the upper left and get revenue traction, especially with some well-known customers.  My company, NetGravity followed this model, locking down media companies for our adserving product early on the Internet and just churning away on sales to $40M in four years.  Situations like the beginning of the Internet don't happen often, so this traditional approach is not always the best.

Modern SaaS companies like salesforce and others changed this path by figuring out freemium models that got them significant user traction.  They give their product away for free with limited features or user caps and get users addicted to convert them to the paid version.  Their monetization depends on the number of free users that they could convert to paid users.  For salesforce, I remember that they were in the 7% conversion range.  Dropbox and other modern Saas companies have also figured out how to be in that magic 5%+ conversion range.  So 95% of your customers use a set of your features for free and you make all of your money on the final 5%.  In the consumer space, this is even more true.  If you figure out a monetization scheme that scales up with customer passion/usage, you will see "whales", customers that outspend the average customer by 10-100x.  Game companies like Zynga are quite dependent on whales.

So how does any of this apply to the way you think about the education market?  The main way it should affect you is the big red X from the upper left to upper right corner.  I have probably talked to 100 edtech entrepreneurs who are going about this market the traditional way, building revenue traction with a few customers and trying to scale up from there.  Here's the problem.  Everyone who has been investing in this space for a while understands the Valley of Death (see my first post).  Most angels and VCs would like to see an exit in 5-7 years.  Since you literally spend your first five years just trying to get sales traction going from upper left to upper right, this approach does not fit well with what typical investors want to see.  You will be very frustrated walking into the offices of these investors.  More likely than not, the "enterprise" partner in the firm will listen for 5 minutes and then throw his body between you and any other partners in the room to try to end the conversation.  He does that because VCs and experienced angels are very good pattern matchers.  Since edtech has been around for 30 years, it's very likely he or a good friend made the mistake at some point of investing in someone going from upper left to upper right.  It didn't work out well and blew a big hole in the floor, and he wants his partners to run the other way.  This is rational behavior on investors part, because that pattern has repeated itself over and over again for 30 years.

So, don't take it personally, but you need to decide what to do about this situation.  Here are a few ideas:

1 - Do you >really< need to sell to schools and districts?  There are some products that you just do.  It's incredibly hard to imagine selling a student information system to parents or teachers.  Ultimately, that's a backend system that helps schools and districts keep track of their kids, so they are the payers.  If you do need to go down this path (and I don't want to discourage you because, believe me, the space needs much better products here) then you need to get comfortable with a couple of things:
    a - you are almost certain to experience the Valley of Death while you get sales traction.  So build your company extremely lean - $50K monthly burn is good here.  You are going to be a Grinder most likely.
   b - go for subsidies.  Whether it is a federal subsidy or philanthropic subsidy, grab it.   Your job is to get through these five years without dying and you will need every penny you can get.
   c - work hard to find other people that can bring your products into customers - If google or microsoft wants you to be a partner on the launch of their next tablet, invest in that heavily.
   d - don't waste a lot of time talking to angels and VCs who are looking for a typical 5-7 year return.  It will be frustrating for you and them.  There are folks in this space with longer time horizons and lower expected returns.  They are dwarfed by the normal institutional investors, but if you go down this route, you are going to need to find all of the patient folks who will stick with you while you grind.

This by the way is the path that Dreambox went down, so I've experienced three years of it.  It can be done, it just takes incredible grit.  The miraculous thing is that once you get out of the other side of the Valley of Death, your company is as good or better on growth and other metrics than most enterprise companies.  This is because the Valley of Death creates a moat behind you, killing off anyone who would like to compete with you.  For investors thinking about the space, the handful of companies like Dreambox will be very appealing.  But that's not going to help you as an edtech entrepreneur when you are launching.  If you have to go this route, put your head down, survive, and get to the point where sales start to feel like normal every day things.  Probably $2-3M in annual revenue is a good point to start feeling better about your chances.  Note that this is not $2-3M in subsidized revenue.  If someone other than schools and districts are paying you, be thankful for the cash, but don't fool yourself that anyone will remember your name when the subsidy is over.  Investors should be very focused on where the money is actually coming from in companies that brave the Valley of Death.

2 - If teachers and maybe ultimately schools and districts are your customers, can you go the modern SaaS route and give away your product to 95% and collect from 5%?  (By the way, getting to that 5% is brutally tough, most companies who get large customer traction can't crack the monetization conversion formula).  Many companies in the space right now are going down this route.  Personally, if you have to sell to the existing institutions, I would implore you to go this route instead of #1 to get around the Valley of Death at least for a while.

Here's the main problem with this approach.  We haven't really seen anyone crack this yet, with the possible exception of Study Island (Archipelago).  They didn't really go freemium, but at $3-$4 per student, it was cheap enough that the market treated it that way.  There are many companies that people are watching here - EdModo, Engrade, Class Dojo and others.  They have a ton of users, now how do they create a revenue model?  One thing I've noticed here is that the "consumer" partners in a lot of venture firms and consumer-oriented angels get interested in these companies.  They have a lot of the same dynamics of consumer and horizontal SaaS plays.  The caveat here is that most consumer folks are used to much larger potential numbers of free customers to convert ultimately.  Dropbox for example already has 50M customers and will likely go much higher if the bigger tech companies can't figure out how to stop them.  By comparison, the entire universe of U.S. based customers (children) is about 60M.  It's true that you will get schools all over the world using your product, but watch out here because to really get large penetration with enterprise type products, you usually have to put some time and energy into understanding market and customer differences from country to country.  Given this relatively (to pure horizontal consumer companies) small market, the way that you get paid matters a lot more.  So the standard - "we are only worried about user traction and we will worry about monetization later" is naive thinking in my opinion.

Serious investors want to at least understand how many hurdles it would take for you to get to $100M in sales.  That's an enormous win, but they go for that goal with every company, assuming (correctly) that most of their companies won't make it.  If you can't build a likely scenario where that happens, you are going to get a pass.  So let's say you really kill it and get 50% market share and 25M users.  If you can convert 5% (again, that's really killing it), you will have 1.25M paying users.  Now,  to hit that $100M sales threshold, you need to make about $80 per student.  That's about 20x what folks like Study Island were able to charge teachers, and it's more than Principals have in disposable expense dollars (about $10K total usually) so it's safe to say you are only going to make that kind of money selling to districts.  Worse yet, districts don't have an $80 per student line item for edtech, so you are ultimately going to try to pull dollars from somewhere else.  I will explain in a later post why blended schools like Rocketship are a completely different and better kind of customer, but for now you should assume that you are back to the Valley of Death.  It's arguably better to be in the Valley of Death with 25M customers, especially if you are able to hit it quickly with 10% weekly growth like the rockstars of consumer and SaaS world.  But still, you are going to be slogging hard for those conversions.  Again, this is the route I would go if I had to sell to institutions, but both investors and entrepreneurs should understand the spending dynamics working against you as you try to skirt the Valley of Death.

I want to pause for a second to make one comment.  If #1 and #2 are so hard, why do people insist on selling to institutions?  When Jesse James was asked  - "Why do you rob banks?"  he replied "because that's where the money is.".  Likewise, enterprise k12 edtech companies asked "Why do you sell to schools?" answer "because that's where the students are."  Like Jesse James though, many of these companies find themselves in jail.

3 - Sell to parents.  Sorry to hold the punchline for so long, I just see many more companies trying to do #1 or #2.  Personally, the next company I start will go after parents.  As an angel, these are the only companies that really interest me.  A few years ago, with the invention of smart phones and tablets, the world changed completely in education, although the institutions didn't really take notice.  Within 5 years, there will be over 1B people with smartphones.  In most developing countries, the conversion from dumbphones to smartphones will happen at double digit growth rates until everyone has one.  Once you have a smartphone or tablet, you can learn yourself.  Period.  So unless as an edtech entrepreneur, you want to go to your grave fighting for the traditional education institutions to survive this massive disruption, I would suggest you think seriously about bringing the education directly to parents and children.

Like #2, this nut has not been cracked yet enough times that patterns have emerged.  People should be watching companies like Motion Math (and the other 10,000 solid edtech companies trying to figure out path #3) incredibly carefully.  The second caveat to #3 is that if you are starting in the U.S., most parents have been trained that education is free.  We just don't pay for things that help our kids learn.  Luckily, this is really not true in a lot of the rest of the world, especially Asia and developing countries.  Check out Bridge International Academies in Africa if you had any doubt about this - http://www.bridgeinternationalacade  So my guess is that we Americans get over the free thing relatively quickly and the rest of the world doesn't have anything to get over.

One other thing to think about if you are an entrepreneur considering #3.  Consumer tech companies who do well typically focus on tech, not content.  That's because content costs a lot more to build and you have to keep refreshing it.  So think hard about how much content is part of your value equation vs. tech.  The more content there is, the more money you have to raise to get a large user base and figure out how to convert users.  Your burn rate is higher, so it's a lot riskier.

Next time I will talk about why blended schools are different for you diehards that want to go enterprise.