Iterations: Traction Capital

math

Editor’s Note: Semil Shah is a contributor to TechCrunch. You can follow him on Twitter at @semil.

There are many misconceptions about technology-focused venture capital out there. One timeless misconception is that venture capital is monolithic. By now, given the attention driving the tech scene and the age of celebrity investors, we all have a better understanding of how an investor’s tastes can range between sectors and stages. And, when it comes to consumer-facing products and services seeking institutional investment, there’s one dimension that nearly every funding decision seems to hinge on these days: “traction.”

I place the word “traction” in quotes because it’s often cited yet not commonly understood. The origin of “traction,” in this context, reverts back to the engineering discipline to describe the tension or adhesive friction created by a pulling force, which perhaps gave birth to the phrase “gaining traction” as the tech community refers to it today. When I think of something gaining traction, I think of physics, where an object has reached enough speed or captured enough energy whereby it sustain movement and momentum on its own.

Semantics aside, let’s focus on traction as a concept, but only for consumer-facing web and mobile products or services under consideration for larger, early-stage institutional investment — not angel or seed funding. Today in 2013, multiple, interrelated forces are at play: While the cost of building and maintaining web and mobile products has fallen, the amount of angel and seed capital in the market has increased, coinciding with a stagnant economy and depressing labor market, all against the celebrity-driven and tech-obsessed social media platforms, which come together to generate, basically, a boatload of new products and companies.

Put another way: There are too many consumer startups that fit into this class, so rather than try to pick potential winners among an ocean of droplets, institutional venture capital firms (especially the larger funds) have employed a strategy of monitoring, waiting, and gathering as much information as possible before putting their money to work. This appeals to a larger investor’s craving for optionality, as well as protecting them from the fickleness of consumer sentiment for new sites and apps. Furthermore, larger VC funds are looking for evidence that a particular consumer product has a good chance of experiencing hyper-growth and maturing into its own durable, standalone company. (Note that “traction” can mean entirely different things at different stages or in different sectors.)

As a result, startups seeking funding often shoulder the burden of proof to explain to potential investors what “traction” specifically means for their product, as well as why the key foundational metrics were chosen in making their case. The startup has the responsibility to show there is not only consumer adoption of their product, but one that is or will be moving at a non-incremental rate. For some products, the metrics could be around a financial data pointing to a high willingness to pay, and for other products it could be a week-by-week cohort analysis which reveals signals leading one to believe an inflection point in adoption could be on its way.

The problem, of course, is there’s no agreed-upon method for agreeing on what defines traction — depending on the startup or the investor, it may be different, or it may be one of those cases of “you know it when you see it.” Some investors elect to focus first on the absolute number of registered users, some want to know more about monthly active users, while others want to know a ratio between daily active users and monthlies, as well as metrics around retention and virality. Some investors will go so far as to model out disparate signals from web and app analytic services to predict the fidelity of these metrics, while others will care a bit less about absolute numbers or ratios but rather focus on how passionate and addicted the initial user base is.

Metrics, however, can also be manipulated to have a distortionary effect and, ironically, lead teams or investors to weigh factors incorrectly and result in costly mistakes, such as raising too much money. Additionally, focusing on traction permits investors to stay close to entrepreneurs while providing a reason to “pass” on a deal until a higher level of traction is achieved. Perhaps having “traction” is a way to open the door to investment, but not sufficient enough to close the deal.

Again, the burden of proof here lies largely with the startup, as it always does. This is why investors want to make sure they see many deals but remain happy to pass and say they’re willing to be proven wrong. Institutional investors with smaller funds, relatively, compete by making these bets early with less traction than bigger funds would need to see. I’m sure there are many investors out there who do make Series A bets without focusing entirely on traction. This isn’t to imply larger investors today won’t take risks — of course, for the right products or people, they most certainly will. But, for the most part, for consumer products today, institutional investing is more like “Traction Capital” today — in order to have a chance to cash the bigger checks, startups most likely have to demonstrate traction first before anything else.

[A note of thanks to Eghosa Omoigui, Josh Elman, and Micah Baldwin for reading drafts of this post.]

Photo Credit: University of the Fraser Valley / Creative Commons Flickr