Li Wei of Shunwei Capital: After investing in 51Talk, I now have four considerations when judging a project

12/7/2016

After investing in 51Talk, I now have four considerations when judging a project. Personally, I prefer not to base my investment decisions on the start-up founder’s ability to garner financing. If the start-up founder is highly persuasive and is able to get a caped hero to bail him/her out, this is something very sad, as the investment would have been made based on what the start-up founder said and not the value of the team and business.

1) The first consideration:

Is the start-up founder simply chasing a fad?

I have worked overseas till 2009, and was able to witness the 2008 financial crisis in London for myself. The scenes I saw were similar to what happens in A Dream in Red Mansions: previously shiny facades crumbled into nothingness in an instant.

The lesson that I drew from this is: while many investment areas and projects may look “in”, you must think through matters such as market demand, business model, industry logic, and if the existence of the project makes sense.

Recently, the “Feng Kou” (an opportunity for the investors) is being discussed again. It would appear that looking for the “Feng Kou” has become the task of the investors and start-up founders. I beg to disagree. Everyone has an idea of the broad trends. However, what is unpredictable is just exactly where the exact opportunity is. And so we just follow the market and leave the thinking to others. Although the “Feng Kou” can give you plenty of financing opportunities, to want to become the “pig (that can fly)” that jumps right into it is not a very wise choice.

Actually, the idea of the “Feng Kou” is both seductive and deceptive. An approach I am more comfortable with is to look at the reasons for the formation of the “Feng Kou”, the push factors, and where the it aligns with my own business; at the same time, you must also understand that the “Feng Kou dividend” brought in by a type of technology breakthrough will certainly come with a lag when it comes to commercial application.

For instance, around 2014 we had already expected the imminent arrival of the 4G “Feng Kou”. There are two types of logic at play here: first, smartphones had already become quite ubiquitous by then, and second, large-flow technologies had already appeared with relatively mature applications in other areas. Hence, everyone felt that there would be tremendous opportunity for high-flow products. This was a logical judgment based on the fact that infrastructure was already mature.

In fact, high-flow livecast platforms like Inke became popular only around 2015 and 2016, and players in this area did not achieve significant success before then. At that time everyone had thought that video-sharing would become a big thing. However, to date, start-ups in this area have yet to achieve hits, with only one player, Kuai Shou, in the market. So even though new business models emerge when infrastructure is mature, just which business model will achieve success depends on the market. There is great uncertainty here.

Of course, there are also plenty of start-ups in the market with their own “Feng Kou”, such as Didi. However, to change the consumption habits of large numbers of consumers, one would have to put in the high costs of market cultivation. It also means that you must fully believe that you will be able to attract large amounts of financing.

Personally, I prefer not to base my investment decisions on the start-up founder’s ability to garner financing. If the start-up founder is highly persuasive and is able to get a caped hero to bail him/her out, this is something very sad, as the investment would have been made based on what the start-up founder said and not the value of the team and business.

These days, there are many people who believe that successful companies attract large amounts of financing, but that is because these companies have survived.There are many more companies that you have not seen, which burn through tons of money and then crash and die. Their only function is to educate the market. As they say, behind a successful general are the bodies of ten thousand dead. What lies behind a successful enterprise is typically a sea of “bones”.

2) The second consideration:

Are there real needs for the project?

After I returned to China, I encountered a number of start-up founders. In my interactions with them, I discovered that the following two issues are common:

The first issue: they want to transform everything. For instance, I have met with some very “luxurious” teams that hope to transform the whole of the education industry by providing elementary and high schools with complete teaching IT systems that will take care of all issues: timetabling, paper grading, corrections, student grade entry, etc. They work on seven or eight product lines at the same time that cover various issues with elementary and high schools at various stages. And then they realize that they do not have a single buyer among schools.

In this example, the start-up team believes that they can use technical means to resolve all offline problems, big and small. However, the cost of trial-and-error is very high in the education industry, and no one is willing to use their students as guinea pigs. Further, the mundane and piecemeal tasks must have existed for so many years for a reason. If primitive methods are enough to satisfy the school’s needs, then there is no need for you to come in with your fancy system.

What this shows is that many start-up founders, who come from internet enterprises, see nothing but issues and demand with traditional industries. However, they have not truly identified the true problem at hand, and are unable to gauge the extent of user demand and how much users are willing to pay to resolve the issue.

Hence, the application of the “internet way of thinking” to traditional industries has to be limited. It is far harder than we think to apply internet technology and logic to many industries. We must respect traditional industries and not come in with the belief that we are superior and all-mighty. Truth is, what you would encounter may leave you all bloody and broken instead of emerging a winner. Only when you respect traditional industries enough and conduct slight transformation in accordance with, and by exploiting, its patterns, would you be able to — perhaps — achieve a good outcome.

The second problem is: the belief that one’s needs are general needs. We often hear a start-up story that goes along these lines: because this happened for me, I decided to do this. For example, some start-up founders develop a strong passion for the mother and child care industry because they had become parents, and they decide to undertake a project in a specific market segment.

How do I determine if these needs are valid? Here, I have three tips:

1) Identify the actual, constant need. Although user needs may look like they are constantly changing, actually certain needs are comparatively speaking, unchanging. Constant needs like these typically represent the actual needs of the majority of consumers, like everyone’s survival needs for services like education, finance and healthcare. Very often, the individual is unable to lead market knowledge in a sustained manner. If you build your business model on a stable need and then focus your resources on reinforcing this model, then your chances of success will be much greater.

In the last few years, super-unicorns like Uber and Airbnb which have seen significant growth have created new supply for what are comparatively constant needs and provided value-for-money solutions. This is why they have been able to create, and win, massive market room.

2) Put yourselves in the shoes of a new user. When start-up teams come for a chat in my office, generally I would spend around half a hour to try out their products and to understand the various functions of the product. This allows me to see if the product has any life to it and if it can generate emotion resonance.

3) Communicate with the user via phone to garner authentic user feedback.

4) Look up the product’s user retention rate. If the next month user retention rate for a product is only 10%, it means that nine out of ten users are lost after a month. What this may indicate is that the product’s target user does not exist, or that the problem is not one the user is in a hurry to solve.

3) The third consideration:

Are there problems with the business model?

Today, many start-up business proposals that we receive contain two common mistakes in their description of the business model:

The first mistake: A misplaced focus on the specifics of the approach and not the issue proper.

Take for instance the online finance industry. Everyone knows that the challenge here is obtaining credit data. Many start-ups end up telling us all about how they plan to collect credit data and how to identify quality customers the moment they come in. However, this is actually not the most important thing. The core of finance is not engaging in business with zero risk but how to establish an effective system of risk controls through structural design.

Based on the current state of the social credit system, the issue of individual credit investigation is unlikely to be resolved in the short term. For example, Shen Ma Finance (which I have invested in) focuses on the granting of loans for electric vehicles in the rural market. However, it has emphasized overall risk control rather than simply focusing on the matter of establishing individual creditworthiness. There are two reasons why we would choose to do this:

1) To a very large extent, village communities are communities based on familiar faces, and the business radius generally extends a few kilometers. Hence, sellers of electric vehicles are generally able to understand and keep abreast of their customer base, and know that this individual is buying an electric vehicle mainly to ferry goods. That is the foundation.

2) Integrate the sellers into the system of risk controls. For instance, if you sell electric vehicles from a particular brand, Shen Ma will first sign a partnership agreement with the brand HQ. Core clauses in the agreement will stipulate that if the default rate for units sold by the seller crosses a certain threshold, he or she will be disqualified as an agent for the brand. This can be fatal for an agent in the town or village context. Nobody wants to break his rice bowl for a tiny bit of profit.

The second problem: while the logic of the business model is impeccable, the practicality of the model is lacking.

Let us take the two education start-ups I have invested in as an example. 51Talk focuses on the skills upgrading market. How do I judge its basic business model?

First of all: the innovative aspect of the business model is based on the traditional business model, with internet tools used to implement some improvements. Fundamentally, it is still about offering offline one-to-one English conversation classes, just that the tutors are based in the Philippines. Such a model has been proven to be viable offline, which is why business has always been steady.

Secondly, the English-language skills of Filipino tutors are pretty good, and labor costs are low, too, with significant growth in this area unlikely in the foreseeable future. Hence, there is the room for profits. Should labor costs rise to the levels commanded by U.K. and U.S. tutors, then the business model will be hard-hit.

The business model should also meet the needs of local consumers. Another education service that I have invested in, Zhangmen 1-to-1, caters to customers sitting for various examinations. This market is massive, and can be easily divvied up among a few market titans with little fear of saturation. Its concept is very simple: students who had done well in the college entrance examination and who had gained entry into top-tier universities tutor students who are currently in high school. These tutors would be familiar with the syllabus as well as learning methods as they have just completed the examination; their exam results are another selling point.

Here, let us look at a negative example of how the business model is sound but the practicality of methods, not exactly thought through. The “explosion” of e-commerce has already proven the viability of the business model. Why then do so many enterprises fail? Now that we look back, we see that it’s because everyone’s traffic cost was constantly on the rise, which meant that the cost of acquiring new users was also constantly on the increase. Growing market competition was something else that had not been well anticipated.

This also tells us that from another perspective, when a large number of investors and start-ups go into a certain area, although it may appear to be a ‘hot’ area, everyone is exploring the deep patterns of the industry.

4) The fourth consideration:

Is the business in a healthy state?

Generally speaking, start-ups and investors pay a great deal of attention to financial statements. However, there is usually some lag to these numbers. Further, the statistical range used also differs from the actual operating situation of the enterprise. Therefore, if you only pay attention to the numbers, sometimes you would not be able to discern the actual operating situation.

What should we look at, then? I feel that we should look at the core operating indicators for the firm in every case.

This core indicator varies from industry to industry, and even from enterprise to enterprise. Just what it is, you will have to figure out. First locate the common industry indicators, then identify the core indicators for the company. Next, I would like to share with you how I identify core operating indicators in the course of making investment decisions.

To take the education industry as an example: many people believe that online education is an internet business, which is why they try to run the business on “internet logic”, i.e., first establish high traffic, then convert a minority of users to paying customers. So, many enterprises spend all the entire operations budget on ensuring high traffic. While this logic is viable for many businesses such as media and social networking, it is not so in the education industry.

This is because the business logic of online education does not depend on traffic. Even if you have a large user base, you may not be able to convert that into significant income. To date, there is no online education company with a large user base which has been able to go commercial well. Therefore, “traffic” is not the right indicator to use in this field.

Some start-ups tell us that they do not focus on traffic but the retention rate; after all, this is a most commonly-used indicators in business case studies from overseas. However, as classes typically take some time to complete, the most important indicator in online education is not the retention rate but the paid renewal rate. This is also the lesson I have drawn from investing in 51Talk.

So do we focus on the paid renewal rate for all education start-ups? Not really. For instance, Zhangmen 1-to-1 depends on part-time tutors who are themselves university students and not professional teachers. Hence, the important thing is to look at whether the tutor’s services are satisfying to the customer. How do we determine customer satisfaction? Apart from the rate of repeat purchases, I have also set satisfaction rate and subject extension rate as the core indicators for this project. The former measures the quality of services being offered (as perceived) while the latter measures the customer’s stickiness of the platform.

Subject extension rate is the percentage of customers who go on to purchase tutoring services for other subjects. The latter rate measures trust of the platform as it is most likely that tutoring services for a second or even third subject would be provided by another individual. Such a decision would indicate that the platform is ‘sticky’.

Apart from helping you understand if a start-up’s operations are healthy, core indicators also help in review. When you invest in a company, it is based on certain judgments and expectations. Now, one can use the core indicators to verify one’s judgments to see if the judgments were correct, or if one had made a mistake. The use of core indicators in such a scenario can even help to identify the error that had been made. I feel that this is also useful for start-ups.

Of course, so far in my experience I have rarely interfered with start-ups’ operational strategies. The start-up founders understand the company’s development best, and what the investor can do is only to judge from a broader perspective. Because we have seen a good number of projects, we have an established ‘coordinate system’ and invest within such a knowledge framework. What I can provide you with are some experiences and lessons of mine. As for business details, pricing, mechanisms, etc., these are things which can only be tested by the start-up through the market.

Finally, my suggestion to everyone is: stick to the fundamentals, and do not get distracted by the frills. Do not look upon entrepreneurship as a game of capital, and do not try to take off too quickly. As far as I know, the main reason why most start-ups falter is because their dreams are too ambitious and are not practical.