One of the reasons I started this blog in the first place is that I think the process of raising money is a black box. I think we’ve made a dent in getting information out there, but at the pre-seed level, it’s still fairly unclear what investors are looking for. How do you assess a company when there is nothing or not much to show?
I can’t speak for other VCs, but here’s what I’m looking for:
1. What is the problem you are trying to solve and for whom?
I can’t stress this one enough. This is probably the single most important thing to me, but as I mention here, it’s probably the number one area that entrepreneurs prepare the least for.
I’ll give you an example with my own startup, LaunchBit, and how our understanding of the problem and the customer became more refined over time:
V1: Helping online marketers get customers profitably.
V2: Helping online marketers who have previously bought ads in email lists get customers profitably.
V3: Helping directors of marketing at series B companies who have previously bought ads in email lists get customers profitably.
V4: Helping directors of marketing at series B B2B SaaS companies who have previously bought ads in email lists get customers profitably.
V5: Helping directors of marketing at series B B2B SaaS companies who have previously bought ads in email lists and are doing lead generation for free trials / webinars / and content get customers profitably.
At the pre-seed stage, a big way to stand out is if you have a V3 statement (as opposed to a V1 statement).
The way you get to a V3 statement is to start running the business and charging customers. Almost all of the companies in whom we invested in 2017 had customers, even if they didn’t have much of a product. Those who didn’t have a product or much of a product used a concierge model à la Lean Startup philosophy to start running their business. By just getting started and exchanging money, you can learn more about your customer persona, his/her daily life, and what makes him/her buy.
Another way to get to a V3 statement is to have been in the industry before and to have experienced the problem you are trying to solve.
At the V3 level of understanding your problem and the customer, you will still have lots of questions and potential customer segments who could be a good fit for your product. We are not looking for all answers to be resolved, but the presence of a narrowed scope is a big divide between those who are ready for pre-seed funding and those who are not.
Although this post is specifically about what I look for, every investor (including pre-seed investors) looks at this question.
2. What is the business model and the potential unit economics?
This one is pretty investor-specific. Certain investors tend to gravitate towards certain business models.
“Five ways to build a $100 million business” by Christoph Janz at Point Nine focuses more on the market size, but it gets at business models indirectly and is a very good post to read.
At a high level, business is simple! 🙂 You bring revenue in and your costs send money out the door. You want your revenue to be higher than your costs.
But the execution is hard. Do you spend lots of time going after big money (enterprise customers)? Or spend virtually no time going after small money (à la Facebook)? Or in between? When you’re talking with an investor, I’d say in general, he/she has biases towards the customer acquisition methods that have made him/her money before. If he/she made money on pure consumer businesses, then he/she will gravitate more towards swatting flies (see Christoph’s post). And, if you have a business that involves getting lots and lots of consumers onboard to pay small amounts of money, that is probably the type of investor you want to work with anyway because he/she will have insights from past learnings and dealings with other companies.
For me, I’m very much in the deer-hunting category, according to Christoph’s post. I’ve also done some rabbit deals. Investors have their biases towards certain business models based on past experiences, and my biases are based on running my company LaunchBit (which was a deer-hunting model) as well as the companies I’ve funded over the last three years.
The reason I like deer-hunting businesses is that from my own experiences, I can see a clear path to bring in sales profitably. You charge a high enough (i.e. high lifetime value) price such that you can get customers through partnerships, outbound sales, and/or lead generation + inside sales, which generally also have some fair cost to acquire customers. It’s not so high that only a small number of people can pay for it, and so you don’t have to get the sales process perfect as a first-time entrepreneur or be a super salesperson. I understand the nitty gritty operations required to do these customer acquisition methods, and that gives me conviction that with the right team, this type of business can fly.
On the flip side, I am definitely the wrong person to help with a fly business. I know nothing about viral marketing. I don’t know how you get that many customers at scale without spending a lot. I’ll pass on those companies because I don’t understand these types of businesses well enough to get involved. It certainly doesn’t mean these are bad businesses! Facebook, Twitter, and Snap are proof of that! It just means I’m the wrong investor-fit. I’ve also passed on a lot of mice and elephant companies, too, because the unit economics feel too difficult to me. This is because I just don’t know how to get customers profitably this way. However, there are lots of investors out there who do know how to do enterprise sales or how to get lots of small customers at scale.
There are cases where I’ve ended up becoming an elephant or a mouse (or a fly) investor, but that’s been in situations where either the entrepreneur clearly knows how to get these customers (i.e., is an excellent marketer) or the company has pivoted.
Now here’s the thing: at a given firm, each individual investor has his/her own biases. If a fund has a champion model (which we do), when an individual at a fund decides to invest, the fund invests. If an individual at a fund passes, the whole fund passes. So, if you can, you’ll want to chat with the person whom you think is best aligned with your company. All too often, entrepreneurs try to pitch someone at a fund to build rapport based on external factors – such as gender; e.g., female entrepreneurs tend to pitch me more than Eric. Or if you went to the same school as one of us. Or grew up in the same town. I think business-model-gravitation should be a bigger factor in whom you decide to pitch (how has this investor made money before?). He/she will certainly be biased towards that.
I can’t speak for my business partner Eric, but he has had a lot more experience with building businesses and side projects with smaller lifetime values. So if you have a mice-business model, you might be better off trying to pitch him than me.
3. Can I get behind the thesis?
At the pre-seed level, all investment decisions for all firms and investors are driven by thesis-alignment. In other words, have I bought into the idea that this is a real problem and have I bought into this potential solution?
Here’s a concrete example of what I mean: when I was pitching LaunchBit, we started out as an ad network for email. All the investors I pitched who believed that email was dead didn’t invest. All of the people we pitched who became our investors had at least one other portfolio company that was doing something in email.
At the pre-seed stage, there is no way to prove that your thesis is right or wrong. If an investor isn’t onboard, just move on quickly. That’s ok. In fact, the best companies are the ones with strong theses. It also means that potential investors will be very bifurcated in their opinions. Let me give you a few examples of companies that have strong theses that are very bifurcating:
AirBnB – investors either believed people would sleep on other people’s air mattresses or not
Uber – investors either believed people would ride in other people’s cars or not
Those van companies that double up as hotels – investors either believe that people are willing to do this or not
Anything bitcoin – investors either believe that bitcoin (or other cryptocurrencies) is massively undervalued or should go to zero; I don’t know anyone who thinks the status quo is here to stay
Investors are going to be wrong in their theses. So, just because someone isn’t onboard because of your thesis, that doesn’t mean it’s a bad thesis. It’s a matter of finding the right investor who agrees with it.
4. If sh*t hits the fan, can the company survive (and grow) on my $25k check?
As a small pre-seed fund manager, I have very different concerns from the Sand Hill VCs. The Sand Hill VCs will support you in every round (if they think you’re good). Me, I will write a $25k first check. I might write another check later, but it won’t be that big, and I certainly don’t have enough money in my fund to lead your next round.
As a result, I won’t be a signaling risk to you, but it also means that I have to think a lot about downside risk. If you are in a really competitive space where it will take a lot of capital to compete and outspend everyone, I might decline to invest. I certainly understand that often it’s the 8th player who comes in and wins (e.g., Google and Facebook), but I don’t have the capital to play in those games. This comes back to investor fit – the big firms are much better poised to fund these highly competitive spaces, not small firms like mine. That being said, most of the time, entrepreneurs don’t know if they are in a competitive space or not until they start fundraising. So if you start raising money and you hear from a few investors that your “space is too crowded,” you might want to think about how it informs your fundraising strategy. It might be difficult to raise money at the early stages because most investors in the seed space have smaller funds (especially pre-seed funds). Once you get to breakout success, raising money from the bigger Sand Hill funds could be easier. So you might think about how to best poise yourself to bootstrap and get to profitability for the next couple of years. Chances are, if three investors tell you that your space is “crowded,” this is a good proxy for what most investors think; smaller funds will be harder to bring onboard. Your wildcards for external funding at the pre-seed stage are angel investors – generally people who know you and are betting on you (and the less active ones may also not see enough deals to know whether a space is crowded 🙂 ).
In addition, going back to #2, I have to believe that you can make money pretty early in your business life in case no one funds you again (or for a while). My $25k check isn’t going to last long. Bonus if my coaching can help you escalate that, but the business model itself has to print money immediately. Long sales cycles or signed contracts that won’t pay you for months is tough as a small investor (see elephant hunting). Similarly, consumers who pay you $5 per month need to be coming in droves in order to get you significant sustainable revenue.
5. Lastly, and most importantly, does the team execute with speed?
This is specific to what I look for and not other investors, per se, and I want to clarify what it means to execute with speed. This means that you are making fast progress on the top thing that matters. For most companies, this is usually sales. In some cases, product and technology.
Let me give you a couple examples of companies that we backed who impressed us:
My first investment on this fund: CEO started selling to top tech companies even while it was a side gig and even before she had a product. She did about $10k in sales that first month.
Another investment: Co-founding team started selling in-person at 5am to their target demographic (that was up at that hour) and hacked together a Shopify store to deliver v1 of their product
We have also backed teams where the product is really technical, and the risk is technical rather than market risk. In those cases, we want to understand how the team sprints and thinks about getting the simplest robust product to launch.
In contrast, there are a lot of teams that spend a lot of time and hard work doing research (market research), surveys, customer interviews, etc. That’s ok, but most people cannot articulate what product they want or what they will pay for. From my own operator experience, the best way to learn and iterate is to actually start working with paying customers.
Note: there are a lot of other important things that I didn’t mention: market size and team. These are going to be really important for other investors. For me, strength of the problem is usually correlated with market size (not always but most of the time), and execution with speed is correlated with team.
In conclusion, from my perspective, pre-seed doesn’t mean just sitting around with an idea. To me, it means the beginning stages of building the company and learning and iterating on those learnings quickly. I am not looking for loads of traction but the ability to have a conversation with a team about what they’ve learned each new week based on something new they tried in their sales or product development the prior week. And if you can do that week over week, you’ll hit some level of success.