The Importance of Validating Your Assumptions

In any given week I might have meetings with 5 to 10 different companies. Most of these companies are early-stage in nature and are often seeking one of two things: Advice and/or capital. If I had to guess, I’d say 10% are seeking advice, 85% are seeking capital, and just 5% are seeking both. For the overwhelming majority of those that are just seeking capital I often see a common pattern in that they often have not yet justified or validated the major assumptions for why they believe their business will be successful.

In an effort to be pragmatic, I understand that not ALL assumptions about a new concept or idea can be completely validated until and unless capital is deployed. In these cases, I do think it is critically important to at least understand what assumptions are being made so that once the experiment is set in motion, everyone can know what should be tracked and measured.

Its always a fun exercise to take entrepreneurs through the process of having them write down their assumptions and then ask them to describe their methodology for testing/validating their assumptions. Not surprisingly, most entrepreneurs (or at least the ones I talk to) do not understand nor have ever followed the basic tenets of the Scientific Method, which is in essence what we’re talking about here. The Scientific Method consists of the following steps:

  1. Systematic Observation
  2. Measurement
  3. Experimentation
  4. Forming a Hypothesis (i.e. Assumption)
  5. Testing the Assumption
  6. Refine and Test the Hypothesis
  7. Repeat process starting at Step #4

We have all heard it many times over and over again that starting and running a company is more of art than a science. But really, it’s a combination of the two. Art is abstract and subjective, but science is fundamental and mostly factual. The ‘artsy’ aspects of a company might be customer preferences for color, taste, etc. The science side of a company is operations, finance, etc. Regardless of what aspect of the business you’re thinking about, I think it’s possible to apply the fundamentals of the scientific method to either side of a company (especially an early-stage company) to effectively solve problems and get things done.

I met with two different companies today who had not yet gotten to the stage of validating their assumptions. In all honesty, I wasn’t surprised by this. My goal in these types of meetings is to help companies understand that it is important to be able to articulate clearly what assumptions they’re making and the process they’re taking to validate those assumptions. From my perspective, it is far more impressive to investors when an entrepreneur not only makes a big claim about something, then immediately supports that claim with evidence. Even if the evidence is wrong, having a strong explanation of the process and methodology used to collect that evidence can be very compelling to investors.

Even though the process of validating assumptions is so important, it often does not always translate into “having a successful startup.” One might ask, “Then why is this process even necessary?” I think it’s necessary for the following reasons. First, the process of discovery and validation is critical for maintaining objectivity and removing as much emotion as possible from the decision making process. Second, incorrect assumptions are expected, but an entrepreneur’s ability to quickly change and reshape their assumptions is a learned skill and that skill is further refined when they have a process to follow. Third, and probably most important, it demonstrates to investors an entrepreneur’s ability to strategize, organize ideas and people, and make smart, justified decisions with the investor’s money.

Another angle to consider is that sometimes entrepreneurs may not have time to validate assumptions. In fact, spending too much time validating assumptions might mean the death of some companies. Time is a critical factor that cannot and should not be ignored. I read a report titled “Performance Persistence in Entrepreneurship” that highlights some of the factors for why successful entrepreneurs are able to create multiple successful startups. One of those factors was “market timing skill.” In short, the authors state that an entrepreneur’s ability to time the market is a skill and good entrepreneurs consistently choose the opportune time and place to start their companies. See the following excerpt from the article:

“Is starting a company at the right time in the right industry a skill or is it luck? It appears to be a skill. We find that the industry-year success rate in the first venture is the best predictor of success in the subsequent venture. Entrepreneurs who succeeded by investing in a good industry and year (e.g., computers in 1983) are for more likely to succeed by doing better than other firms founded in the same industry and year (e.g., succeeding in computers in 1985). More importantly, entrepreneurs who invest in a good industry-year are more likely to invest in a good industry-year in their next ventures, even after controlling for differences in overall success rates across industries. Thus, it appears that market timing ability is an attribute of entrepreneurs. We do not find evidence that previously successful entrepreneurs are able to start companies in a good industry-year because they are wealthier.” *(source)

“Time” and “Market-Timing” are indeed different, but in essence they are the same. In business, you need a method to follow to make timely and good decisions. You also need to be able to implement your decision-making methodology within a reasonable amount of time so you don’t miss out on what are often limited-timeframe opportunities for capturing value in your market.

In conclusion, I think the practice of validating assumptions is an important exercise for entrepreneurs (and for anyone for that matter). The process of forming hypotheses and collecting evidence to support them can often make the difference between success and failure in a new venture. Spending too much time collecting loads of evidence can sometimes be counterproductive. But I would argue that it’s better to spend a lot time on the frontend validating your assumptions instead of later wishing you would have, but didn’t. Cheers – KM

*Source: Journal of Financial Economics, Performance Persistence in Entrepreneurship, Gompers, Kovner, Lerner, and Scharfstein (2010)

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