Early stage fundraising is an interesting beast because there are all kinds of reasons why VCs invest at this stage.
Some background
There are essentially two camps of investors: a) those with a concentrated portfolio and b) those with a large, diverse portfolio.
Diversified portfolios:
Funds like YC, 500 Startups, and Techstars all have diverse portfolio strategies. They invest in lots of companies. Say, on 100 companies in a given portfolio, there may be a lot of losses, but a portfolio of this size only needs a couple of outsized winners to not only make up for the losses but also to return great multiples for the overall fund. Because downside risk is mitigated by investing in a lot of companies, funds that utilize diverse portfolio strategies often have consistent results fund after fund – there isn’t as much variation across funds as you might see with a concentrated portfolio.
Concentrated portfolios:
Funds like Sequoia, A16Z, and Benchmark all have concentrated portfolio strategies. They invest in few companies, so there’s little room for error. Of course, any outsized winners will make the overall fund really, really fantastic because there are not that many losses for which to compensate. These funds tend to have high variability across the industry. Certainly there are top tier funds who are able to consistently return solid multiples fund after fund, but there are also many, many more funds who can’t even return 1x because the variability in this model is very high. In other words, compared to the diversified portfolio model, this model is much higher risk and higher reward (for better or worse).
A couple of thoughts:
1. Some funds invest early to capture more ownership. Others want to buy an option.
This is a point I didn’t fully understand until I became an investor. Because large Sand Hill VCs largely make their money on a concentrated portfolio strategy, they need be really, really confident that their investments are going to work out.
By the time startups get to the series B level, it’s fairly clear whether a business is working and printing money. Hot companies are highly sought after. It’s very competitive to try to win a hot series B deal because every investor is chasing the same company. As a result, there are a lot of large funds that will essentially buy a much smaller option at the series A level to be able to get potential access to a hot series B deal. If some of those series A deals don’t turn out to be excellent businesses, then it’s just a small amount of money relative to the fund that didn’t work out. If there is a hot deal in that group of series A deals, then it provides access to pour in tons of money and make a lot of money at the series B level. Funds that make their money on later stage deals and who only invest at the earlier stages to buy an option don’t care so much about valuation. They are only trying to buy a seat at the table to invest a lot in your company later when it’s clear you’re a winner – they are not trying to buy any ownership now.
In the past couple of years, series B deals became way too hot and competitive. A number of big funds have come down to invest at the series A to increase their optionality on capturing winners at the series B level. Now that seed and series A are starting to bleed together, you are now seeing some large Sand Hill VCs do seed deals again.
In contrast, microfunds (small funds) largely only invest at the earliest stages (seed stages) because their money only goes far at these stages. For most of these folks, they are trying to capture as much ownership at the earliest levels because they do not have more capital to invest at the later stages.
2. In general, microfunds are more valuation sensitive than bigger funds
As a result, because microfunds are trying to capture most of their ownership in a company at the earliest stages, they are going to be much more sensitive to valuation than a fund that is just trying to buy an option to invest in you in later rounds. I’ve noticed that this can be a difference of as much as 2-3x on valuation caps!
In general, funds that do fewer (or no) follow-on checks will be more sensitive to valuation because they really only have one or two chances to buy as much of your company as possible.
Obviously, from an entrepreneur’s perspective, valuation is an important consideration, but it’s not the only one. Even though larger funds will tend to be willing to invest at higher valuations, there is also more signaling risk that comes with an investment that is perceived as an option-investment. In other words, if a fund invests in your company, if they typically make their money on series B rounds, and if they don’t invest in your series B round, many investors will wonder what is wrong with the company. In contrast, no one cares if a small microfund doesn’t follow on because they don’t have the capital to do so and are not known for doing so.
So hopefully this provides some context as to how investors of big and small funds are thinking about your valuation. Ultimately, valuation is really a matter of supply and demand, as I’ve written about before. If no one is demanding your round, then it’s a moot point. If everyone wants in, no matter how valuation-sensitive the microfund, they may get swept up in clamoring to invest in your round.
I took a look at how we invested in 2017 and thought I’d share some surprising and some not surprising findings. I realize that investors are often a black box; it’s hard to understand what they prefer and what their biases are. Hopefully sharing some of these stats will help illuminate what we care about.
Note: these stats are based on first checks we did in 2017 under Hustle Fund; I did not include follow-on checks.
1. We invested in many places but not in enough places.
Our mandate is to invest in US/CAN entities, so almost all of our investments are concentrated in the US and Canada (except for 1 company). All are legally incorporated in the US and Canada. Here’s the breakdown from last year:
Some quick thoughts:
We invested in way more Bay Area companies than we had anticipated.
We made no CAN investments! :(
Though we did not do any investments in TO/Waterloo, Atlanta, Boston, or really anywhere in the midwest in 2017. We have done a TON of investments in these locations in the past and will likely look heavily there in 2018. A big reason for this skew is that we’d known a few companies – either colleagues, friends, or founders we’ve worked with before – whom we wanted to back right out of the gates. In the long run, however, on this fund, I expect the Bay Area to consist of around 35-40% of our investments.
2. Almost half of our companies have at least one female founder.
47% of our portfolio companies have at least one female founder. In most cases, she is the CEO. Although this is probably better than most VC portfolios, in the long run, I think we can still do better.
Note: for this stat (as well as the next one on race), we asked our founders to self-identify. What I would love to understand, though I think it’s impossible, is what the overall funnel looks like. I can’t tell you if 47% is actually a good number or not because I don’t know what percentage of the companies who are pitching us have at least one female founder (we do not ask about gender or race of our applicants).
That being said, my intuition is that the vast majority of pitches that I get have at least one female founder. I don’t know if that is because my networks are different from Eric’s or if women prefer to pitch to female investors. Maybe it’s purely coincidence. I suspect there is something interesting here, and you could make a strong case for having funds run by GPs of different backgrounds and networks.
Lastly, pitches that start out with, “I am a female founder,” actually make me think that a founder doesn’t know how to run a business. Investors are in the business to make money; I really don’t care about how you identify, as insensitive as that sounds. I’m doing this to make my investors money (and hopefully some for me too :) ). Here in the US, green is always green.
3. The racial diversity in our portfolio is OK but could be a lot better.
Again, these stats are based on self-identification. One thing I noticed is that our mixed-founders identify as “other,”so if someone is, say, half Black and half Asian and identifies as “other,” he/she does not get included in any of the below stats.
20% of our companies have at least one Black founder.
7% of our companies have at least one LatinX founder.
53% of our companies have at least one Asian founder.
53% of our companies have at least one White founder.
None of our founders identify as Native American.
I am happy with this start, and our portfolio is probably better than most VC portfolios, but I’m sure we could do a lot lot better and have a number of efforts planned for later this year.
Again, I would’ve loved to have examined the pipeline of companies we looked at but did not invest in, but this is just not logistically possible.
4. We do not always meet our founders in person.
In 27% of our investments, we still have not met the founding team in person.
I think this is pretty unusual for most VCs. There are a few premises of why this is possible:
I’ve hired a lot of remote folks before for my startup, so remote-coaching, which is a lot less hands-on, certainly works
This allows us to invest in geographies where we are not physically located
You don’t actually really know-know people based on location; it’s based on time and interactions
Business success is based on results, and I can see that in other ways
In addition, I usually try to have most of my initial conversations with people over email before we hop on a call. This is a tip I learned from my mentor David Hauser (founder of Grasshopper, acquired by Citrix) who actually invested in my company LaunchBit over email! It’s a lot more efficient to cut to the chase and not waste anyone’s time in an email, and I can send a quick email with a couple of questions at midnight.
I suspect, but have no data, that this process of first talking concretely about a business over email and then moving people to a phone call actually removes a lot of unconscious biases. I have no idea what people look like or how they dress or if they’re pregnant or whatnot. Again no proof, though.
43% of our companies are B2B companies, but even the companies I’ve put into other categories are also either B2B SaaS companies OR have a B2B partnership model to get consumers.
I’m not sure whether stating this will either attract more B2B companies or deter consumer companies, but regardless, I thought that I would mention this stat. We do try to keep an open mind going into all deals, but clearly we have our biases.
In 2018, though, I can tell you right out of the gates that we’ve been doing so much more in blockchain. So, we’ll see a bit of a sector skew.
6. We invested very early in 2017. And love Lean Startup 101.
60% of our companies were extremely early (e.g., product was rudimentary, concierge-based MVP, etc.), but a common characteristic of the companies we backed was having sales despite having essentially no product. Many of these founders hustled sales before having a strong or fully-fleshed out product. You might assume that the typical Hustle Fund founder profile is sales or marketing oriented, but this isn’t necessarily so. Some of these teams only have product or engineering founders, but the impetus behind having a limited product is to make sure that you’re constantly learning from customers and users and that you’re only building out what they want, resulting in faster iterations.
Essentially, we really like founders who are very good AND FAST at the Lean Startup Methodology. This is something we are quite biased towards: getting results even before having a full-fledged product to inform product decisions.
As I’ve written about before, 2018 is a different fundraising landscape (and still changing!). We are looking for more traction in our 2018 investments in most categories than we were in 2017. This is partly because our founders will need to achieve more in order to get to their next round. By investing too early with such a small check, there’s a long time span between our check and the next round. As a small investor, we need our companies to get to the next round with very little capital.
Hopefully these stats are illuminating. In 2018, I think we will see a lot of changes along geography and race as we ramp up our own activities. We will likely see little to no changes along gender lines. I suspect we will also see some changes in sector (more blockchain & health) but still tons of B2B in one way or another. Probably lots of changes in traction levels as well. We’ll see at the end of this year!
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.
It’s taken me a couple of years to grapple with this but let’s just put this out there: fundraising in the Silicon Valley is very much a game of pedigree. It’s something that startup investors talk about in vague terms. Investors say things like: “This founder is very fundable” or “This founder doesn’t pattern match.” Ellen Pao talks about this explicitly in the excerpt of her new book, Reset:
Predicting who will succeed is an imperfect art, but also, sometimes, a self-fulfilling prophecy. When venture capitalists say — and they do say — “We think it’s young white men, ideally Ivy League dropouts, who are the safest bets,” then invest only in young white men with Ivy League backgrounds, of course young white men with Ivy League backgrounds are the only ones who make money for them. They’re also the only ones who lose money for them.
This is an incredibly telling statement. As an early stage investor, I know that if I can invest in a team that fits exactly what Ellen describes (or MIT/Stanford, or Facebook/ Google), I’ll win in the short term. It doesn’t really matter what the team is doing or how well they execute. I know that some investor down the road is going to be enamored with the team’s resume, pick up that team at a higher valuation, and fund them. In fact, I’ve seen this happen over and over with my portfolio companies who have pedigree – even with the teams that are not able to execute well! And since gains in most investors’ portfolios are on paper only and are not realized for 7-10 years, executing on this strategy is a short term win for early stage investors such as myself, even if companies die 5-7 years later!
Knowing that, you have to believe that your portfolio companies can get downstream capital because, as a small investor, you won’t be able to invest at the series A round and beyond to carry your companies forward. So if you are interested in investing in a company that doesn’t fit the “classic pattern,” then you have to think through all the scenarios if such a company is not able to raise money. You have to have so much conviction that the company will survive through all the tough years before traction really takes off. You have to believe that the founders are willing to eat glass for breakfast every day – 100x more than a team that can easily get VC investment. In other words, the teams I’ve backed who do not have pedigree are 100x more tenacious and stronger than those with pedigree. I’m aware that the world will treat some of my children more harshly than others simply because of the way they look or sound or where they went to school or didn’t go to school.
It isn’t fair. But it’s business. And that’s how things are. Today.
I’m optimistic the world is changing, and it’s changing at a faster pace than ever before. Just a couple of years ago, AngelList announced their syndicate feature. This allowed angel investors to accumulate more fire power behind their small checks. Gil Penchina, for example, a rainmaker angel investor, could get his 99 friends to invest alongside him, which brings his total investment power to millions of dollars. This was an incredible innovation in startup investing. It meant that small investors could essentially band together to lead a series A round. Small investors could have conviction in companies where traditional VCs do not.
This is just the first step. By democratizing money – i.e. truly commoditizing money – it means that founders not only need not rely on the 50 or so Silicon Valley VC firms for serious cash, but it also means that a lot of companies that are growing quickly but don’t fit the right “pattern” VCs are looking for will be able to get funded by others who have conviction in their businesses.
Syndicates are logistically challenging. You have to rally all of your 99 angel friends to participate. And if they don’t, you still don’t have a lot of fire power alongside your small check. Frankly, most of the time, your friends are too busy to partake and to be evaluating all these deals, since this is not their full time job. Moreover, as a founder, often you are limited to only fundraising from one syndicate at a given time, which limits the number of groups of people you can raise from. Moreover, these syndicates are often limited to investors from certain geographies by both legal and practical reasons. Net-net, syndicates have increased the power of small investors by a lot for some, but for most small investors, they still do not have enough money behind them to be able to lead rounds.
Enter ICOs (initial coin offerings).
The Benefits of ICOs
I’m incredibly bullish that ICOs will really empower all kinds of investors – large and small – to make investments in founders in whom they have conviction without caring if the 50 Silicon Valley VCs will have that same conviction (or if they’re conflicted out). Although tokens will be subject to securities laws, I think ICOs will provide the following benefits:
1. Greater geographical access.
In other words, investors from other parts of the world or even within the States (both big and small investors) could partake in fundraising rounds in Silicon Valley and vice versa. Today many people simply don’t have access to deals being done here in the Valley.
2. More efficient infrastructure.
Today, there is a lot of friction and just general inefficient infrastructure around deals. ICOs circumvent problems that you find with traditional banks – wire cutoff times, wire fees, currency exchange rates & fees (to a certain extent), in some cases, legal paper work printed and physically signed. Technology, in general, is a good way to get rid of anachronistic practices. Why are there wire cutoff times in this day and age? I’ve been told that some microfunds pick their banking partner partly based on the wire cutoff times. Shouldn’t everything run 24/7 now?
3. Objectivity in evaluating companies.
Founders won’t be judged on appearances. When you walk into a typical VC office today, if you’re tall and have a booming voice, you’re already at an advantage. Online, none of this matters. No one cares if you’re good looking or can talk well or if you’re tall or if you’re pregnant. All that matters is that you can run your business well. This is the promise that I see in ICOs – that you’ll be judged by your execution and merit rather than by how you look and sound. We’re still VERY FAR OFF from this vision, and many of the pieces that are needed to get to this point don’t exist today. However, this is the direction that I see ICOs going in. We are living in a new, incredibly fast-paced era for startups, and I am so excited to see the playing field finally start to level out for entrepreneurs everywhere.
Yesterday, my employer 500 Startups organized a conference in LA called the Unity and Inclusion Summit. The focus was on diversity issues in startups, and one of the central topics was on unconscious biases in the industry.
This is a really important issue that often gets shoved under the rug. I can’t begin to tell you how many times I hear people say stuff like, “Oh, well, I don’t see a problem — Silicon Valley is a meritocracy.” Or, “This issue is a gender issue; it doesn’t apply to me.”
But this could not be further from the truth. Everyone should be concerned. For me, one of the big problems that I have with the current startup ecosystem is that I think there are a lot of founders who don’t get a fair shot to demonstrate their merit when it comes to fundraising. That’s a priority issue that needs to be solved. Unconscious biases in how investors assess founders can be tied to gender or race, but it extends much further than that. For example, there are investors who have unconscious biases against introverts or non-pedigreed founders. If you have a certain kind of foreign accent, you should also be concerned about investors who are unconsciously (or consciously) biased against you.
The problem is that it’s hard to know to what extent there’s a lack of meritocracy. If a female founder gets dinged, is it because she didn’t get a fair shake? In this industry, frankly speaking, most founders are not going to be able to raise money. The odds of raising are against ALL founders. Period. So, if you get dinged, you can’t simply say, “Oh it’s because I’m a woman that I wasn’t able to raise.”
Investor Paige Craig of Arena Ventures eloquently theorized yesterday at the conference that part of the reason we have this big problem with unconscious biases in this industry is that we don’t have a framework to assess founders. I think this is spot on. Assessing founders is highly subjective. I hear my peer investors (both at and outside 500 Startups) say things like, “Oh, that founder is so sharp,” or, “That founder has a lot of hustle.” Do you really know after meeting someone for just a handful of times if someone is smart or has hustle? You don’t really know the person. What you do know is that you are taking your life’s experiences and trying to superimpose what you’ve learned about other past people you’ve met who seem similar and apply them to the founder at hand.
My framework
As Paige mentions, the way to really tackle unconscious biases when making investment decisions about founders is to have an objective framework. Here’s mine; it’s a work in progress:
I value these 3 traits of founders: speed to accomplish things, learnability, and tenacity (there are, of course, other characteristics that are very important to me in choosing the people I do business with more generally speaking, including honesty and integrity, but for founders, I focus most on these 3 traits as a starting point.)
It’s important for me to be able to point to enough facts for each of these characteristics.
1. Speed to accomplish things
One of the best indicators that I’ve found to measure speed is if a founder says he/she will do something by a specific constrained time and then does it (and repeats this pattern consistently).
For example, if I meet with a founder this week, and he says that he will do xyz by next week, when next week rolls around, I might check in and see if he has done it. If this pattern is consistently positive for several weeks, you’ve got someone really special here.
I realize this sounds ludicrous because shouldn’t everyone be able to follow through with what he/she says he/she will do? As it turns out, most founders I meet are not able to do so. Something comes up and task xyz doesn’t get done. Or maybe the founder is not good with time management or scoping out reasonable goals within short periods of time. Or maybe there is conflict with the team, and the founder isn’t able to work with people well. Or maybe the founder is distracted by speaking at too many conferences. It doesn’t matter the reason a founder doesn’t accomplish his/her micro goal. The ability to quickly accomplish tasks that you set out to do is a very objective criterion that I like to use when I assess founders.
When we say things like, “Oh she is such a hustler,” we really should say things like, “Oh this person sent out 2000 outbound emails last week. And 1000 the week before.”
2. Learnability
This is a tough criterion to assess objectively.
To a certain extent, this criterion is tied to coachability. If I give a founder a piece of feedback this week, has he/she changed something about himself/herself or the business by next week? At the same time, I don’t necessarily believe that my advice is right or best; in fact, it’s a founder’s job to assess whether or not to take advice. If a founder doesn’t take my advice, I’m ok with that; it isn’t a negative mark, per se. If a founder does take my advice, and implements it quickly, that’s an indicator that he/she can learn quickly.
Other ways I assess this is when hear from a founder about a time he/she taught himself/herself a new skill. When I hear about how he/she accomplished his/her goals, I ask about what he/she had to learn along the way.
Instead of saying, “This founder is smart,” which is subjective, I prefer to say, “This founder learns quickly because he/she taught himself/herself enough Python last week to throw up this script to scrape ABC.” Starting a company requires founders to constantly learn new things quickly, so this is a really important piece of criteria for me.
Learnability is very different from being “smart.” People who go to, say, Ivy League schools have proven they have strong skills in being able to take tests and do well in them, but these skills are very different from the ones you need to run a company. They don’t transfer over at all. The best founders are constantly learning new skills they don’t already have and are mastering them quickly.
3. Tenacity
The last piece of criteria is also really hard to assess objectively. If a founder has a story about how he/she powered through a difficult situation (cancer, a rough childhood, etc.), then that’s a plus. Most people don’t have a crazy adversity story, so this one is tough. Often, I just end up not having any data points on this criterion.
These are the three characteristics that I look at most when I evaluate founding teams and try to come up with facts to support a case for each point. This isn’t always easy, but the more facts there are under each of these, the easier it is for me to assess a founder.
Of course, founder assessments alone do not make an investment decision. Other criteria are just as important and in some cases more important: market, whether a company will be able to raise further, existing traction, product-market fit, etc. Given that assessing a founding team is a really critical component to evaluating an early stage investment opportunity, being objective here is really important. At the moment, my framework for this is OK, but it can definitely be improved. I’m open to any thoughts, suggestions, and feedback.
Over the last year or so, I’ve been writing about tactical fundraising to try to help new entrepreneurs with their seed rounds. But, having been there myself, I realize that even with all the help in the world, it’s still really really hard to raise a seed round. Everywhere I go — whether it’s here in the Bay Area or on the road — entrepreneurs tell me that it just takes so much time to connect with investors. Entrepreneurs whom I meet aren’t lazy, but when faced with balancing the needs of a business and spending the time networking with investors, it’s a hard tradeoff.
So, I’m trying a little experiment here on my blog. I’m starting an interview series with new investors — both new VCs and angels. I want to try to connect relevant entrepreneurs with new investors and help new investors get more qualified deal flow and exposure.
We’ll see how this works out, but for the time being, I’ve invited a few active investors to do guest interviews with me in the coming weeks. All of these investors have done at least one seed investment in the last 6 months, but most have done many investments. I want to make sure that all of my guests are actual investors and not just posers or investors who are sitting on the sidelines.
These interviews will be done online but will be highly interactive. I’ll ask questions during the interview, but I also expect attendees (entrepreneurs) to bring their own questions. This means that the attendees will be highly curated. In order to attend, entrepreneurs will need to fill out a quick application form, and I’ll pick entrepreneurs who are a good fit to join me in a conversation with my guests. And I’ll share those applications with my investor guests as well as with 500 Startups. If there are more qualified applicants than slots, first priority will go to my newsletter subscribers. Afterwards, I’ll publish the interviews to the public on my blog.
I’m pleased to announce my first guests. They are the founders of a new VC firm called SoGal Ventures, Pocket Sun and Ellie Galbut. They run the same firm but cover slightly different areas, so I’ll be interviewing them separately.
About Pocket (from the SoGal website)
Pocket Sun founded SoGal, one of world’s largest communities of diverse entrepreneurs with 10 chapters worldwide. She has advised on dozens of startups across Los Angeles, Silicon Valley, China, and Southeast Asia. She was on the cover of Forbes Asia as a 30 Under 30 in Venture Capital, a LinkedIn Top Voices in VC & Entrepreneurship, and was featured on BBC, CCTV, Inc., The Straits Times, Harper’s BAZAAR, etc.
Born and raised in China, Pocket is bicultural and bilingual. She holds a Master of Science degree in Entrepreneurship and Innovation from University of Southern California, and a Bachelor of Business Administration degree from College of William & Mary.
Pocket will be joining me on Tues 12/6 at 9pm PT and in her words, invests in:
Smart Hardware
Next-gen Consumer Tech
AI-powered Enterprise Tech
Diverse Founders
Teams based in Asia
Pre-Seed/Seed Stage
About Elizabeth
Elizabeth Galbut is a venture capitalist and business designer. Prior to finishing business school, she founded A-Level Capital, the first student-led venture capital firm powered by Johns Hopkins students. Prior to graduate school, Elizabeth was a strategy & operations consultant at Deloitte Consulting focusing on large healthcare clients. Outside of her client-facing work, she contributed to business development efforts that led to over $200M of new work.
Elizabeth holds a MBA/MA Design Leadership Dual degree from Johns Hopkins University and Maryland Institute college of Art. She is also a proud alumnus of Georgetown University and London School of Economics.
Ellie will be joining me on 12/13, tentatively at 1pm PT and in her words, invests in:
Health Tech
Next-gen Consumer Tech
AI-powered Enterprise Tech
Diverse Founders
Teams based in the US
Pre-Seed/Seed Stage
Ellie also separately also invests on behalf of A Level Capital, which is a VC firm for Johns Hopkins students and recent alums. And, she’ll be looking at relevant deals for that fund as well.
To apply to join one of their interviews, please fill this out below:
It really pains me to write this post… but it has to be said. I was comparing my small personal angel portfolio and my investments at 500 Startups, and I noticed that on a percentage basis, the companies in my personal portfolio have been able to raise more money on average and more easily than companies in my 500 portfolio.
Why is that? My thesis in how I pick companies remains the same across both portfolios. All of the companies I pick are at roughly the same stage — all seed companies who have launched a product and have some semblance of traction, though this ranges quite a bit.
The #1 difference between my personal portfolio and my 500 portfolio is that my personal portfolio consists of all friends’ companies. And, all of those founders have pedigree. They haven’t necessarily had past earth-shattering success, but they went to elite schools. They worked at elite places, generally at fast-growth unicorns. One group isn’t necessarily smarter than the other, but the branding on people’s resumes have made all of the difference.
(Update: A reader asked me if I’m perpetuating the problem by only personally investing in founders with pedigree – great q, and see the comments below for the clarification on this.)
Take Company X, for example, in my personal portfolio. They have limited traction, especially given they’ve been around for nearly 2 years. They are in a space that is a bit crowded. I erroneously thought that it would be really difficult for them to raise money, but it was a walk in the park. They raised $3m+ with a whole group of name-brand investors!
Then take Company Y, a 500 company I’ve worked closely with for the last couple of years. They have really great traction and high consistent growth for as long as I’ve known them. They, too, are in a space that is a bit crowded. The team isn’t from the Bay Area, and they are college dropouts (but not like Bill Gates or Mark Zuckerberg). That said, they are really clever founders. Despite their results, it has been very tough for them to raise. They have raised some money, but it has been way more difficult than it should have been given that the business has great unit economics and results.
A few thoughts on all this:
1. Knowing all of this, the way to get quick markups is to just invest in a lot of teams with great pedigree. In the short term, this is how to show that your portfolio is doing well!
2. But in the long term — say several years, I wonder how the two portfolios will compare? My fear for Company X is that fundraising has been so easy for them, they won’t be able to achieve the traction they’ll need to raise a Series A. Investors may go gaga for their team pedigree now, but at the series A, they will not get a pass — they will be expected to show results. My fear is that they will be not be hungry enough to move quickly to hit series A benchmarks because they don’t realize the game will be different for them at the next round. Companies that have an easy time fundraising in the beginning tend to think that’s how it will always be. And this is dangerous thinking. If you’re in this situation, you should be very cognizant of this.
3. For my companies who don’t have founders with brand names on their resumes, my fear is that even if they have great businesses and can kinda bootstrap, they will be a bit undercapitalized. They need to be above-and-beyond persistent in getting to know investors so that they can bring in some money over time. Even if it’s tough to raise money now, eventually, business metrics will trump everything else at the later stages; that’s what investors will care about then. Founders who don’t have pedigree but are running great businesses will do better at fundraising later. So, if you’re in this camp, just hang in there.
At the end of the day, doing a startup isn’t about how much money you can raise. It’s about running a great business, and I’ll need about a decade to tell you which of my two portfolios has done better. But, you can’t deny that companies that can raise money are better equipped to compete. It troubles me that the elite truly have a leg up in raising money. When you think about it, this cycle continues because if investors want those fast markups to help raise their next fund in a couple of years, they should definitely invest in founders with pedigree; they will have great unrealized gains to show potential limited partners.
I truly believe in looking for strong business fundamentals and also believe that great founders come from all walks-of-life. And yet, when I make a bet on teams without pedigree, unless they are in a hot space, I know that they will have a really hard time raising money in the short term (and it will affect my short-term IRR as well). In these cases, I have to believe these founders have enough hustle to survive a long time with limited resources while accomplishing significant results. And if I don’t see the hustle and determination, then I just really can’t make the bet.
Wrapping this all up, I don’t have any solutions, but this is a serious consideration for the industry: how do you level the playing field for entrepreneurs?
This post isn’t for you. You are probably trying to get your round done and this post won’t help you with that. This post is mostly for me. Sorry.
Two years in, people often ask me what it’s like to be an investor, what I like and what I don’t like. There are a lot of things that I think are wrong with the VC industry (and I could talk about that for 20 posts). Focusing on the activity of investing itself, these are my best and worst days.
The worst days
The worst day as an investor are the days when you need to reject entrepreneurs. Last week, I had to send out rejection letters to everyone who didn’t make it to 500′s seed program, which just started. We have a limited number of spots, so by definition, not everyone is going to make it. Every batch, I procrastinate on doing this activity.
There are a lot of great businesses that we just can’t invest in (for now).
That’s just the unfortunate truth. Even though we do a lot of investing, we just can’t invest in every good business. There are also business models that we just can’t invest in — for example, we don’t invest in brick and mortar businesses. That’s just not what we do. Similarly, we don’t invest in gaming or pharmaceuticals. We just don’t have an understanding of these areas.
In addition, because there is always limited capital to deploy, we have to pick companies who can best utilize our investment now. In many cases, this means that we need to turn down companies that are not at the right stage, even if the founders are really smart, tenacious, and awesome. We just can’t get involved in many businesses at this particular time. That bums me out, but it’s business.
When we send rejection emails, the above thoughts don’t often get conveyed. Having been rejected by lots of investors before, I have previously thought, “Oh, they didn’t like me,” or, “They think my business sucks,” or whatever. It isn’t necessarily that at all. It could just be that this isn’t the right fit or the right fit right now. Whether you are getting a rejection from 500 Startups or someone else, it is still worthwhile (if you want) to reapproach an investor. If anything, investors who have spent more time with you rather than less are more likely to be your advocates, because they have gotten to know you.
The best days, though, are the days when I get to talk with entrepreneurs, and they leave feeling inspired.
This doesn’t happen all the time (or perhaps even most of the time), but it’s a great feeling when it does happen. This happens with portfolio companies and even in meetings with entrepreneurs who are pitching their business to me. The best example that I have comes from my own experience when I was an entrepreneur. I remember talking with Jason Lemkin about our customer acquisition process at LaunchBit. I was telling him about the outbound sales methods we were using. It was working; my cold emails were effective. But, it wasn’t scaling well. He had a particular insight about structuring the roles on our team, and that was an “aha” moment for me. I walked away from that meeting feeling super pumped.
As an entrepreneur, you often feel down in the dumps. Lots of things are not quite working or not quite working well. You may be so close to making something about your company really soar, and yet you often feel so far away and may even be tempted to throw away whatever is sorta working. Inspiration comes from the meetings where you get some interesting insight that you can put to work right away that will have a huge impact on your company. As an investor, I love being able to provide that or even just some encouragement. If an entrepreneur walks away feeling either super pumped or a little better about themselves / their business, those are the best days.
On Friday, I spent a couple of hours at my alma mater talking with student entrepreneurs about their companies. When I got there, most of them wanted to know how VCs pick their investments and what 500 Startups look for.
I didn’t answer this.
Instead, I said, “Let’s pretend we’re all forming a VC firm right now. And there’s an entrepreneur coming into the room in 10 minutes. What questions would you ask him/her to decide if you’re going to invest?”
I wasn’t sure what people would come up with, but here’s the list of questions the group collectively came up with in 10 minutes with my commentary in brackets:
Team
Do you have a strong team? [Get more specific – what does that mean?]
Does the team have particular domain knowledge or expertise?
Have the co-founders worked together before?
Can they change directions quickly if needed and make fast, difficult decisions?
What is the market size? [I have disputes about this one but that is a topic for another post]
Problem and solution
What specific problem are you solving?
[Why are you doing this? Motivation?]
What makes your solution unique or differentiated?
Is there any special tech or IP here? [In many cases, probably not worth asking]
What is your unfair advantage? [Often there is little-to-none in the beginning but worth asking about this to see how entrepreneurs think about this and see if there is special domain knowledge or special relationships & partnerships]
What is the cost of equity ownership? [May or may not ask this depending on if our hypothetical VC firm leads rounds or not]
[What is a team’s burn rate?]
Obviously, if we had brought in a real entrepreneur to talk with, the list would also include more specific questions about the particular business and/or how the product works.
I was pretty impressed by this laundry list of questions they generated – not bad for 10 minutes! It looks like I can go retire on a beach somewhere.
Inspired by my friend and colleague Andrea Barrica, I want to reflect a bit on what I learned in 2015 about seed investing.
I joined 500 Startups as an investor in April 2015, where I run the Mountain View accelerator. Since then, I’ve led or strongly advocated for 30-40 investments, and I’ve analyzed a lot of data from 500 Startups’ near 1500 portfolio companies.
These are my biggest takeaways:
1. Product-market fit trumps all
As an entrepreneur and now as an investor, I’ve met a ton of highly accomplished, smart founders with strong domain expertise. I’ve also seen many of these people fail to grow their business because they just can’t find product-market fit. A smart founder can increase his/her chances of success by being self-reflective and trying to pivot around to improve the unit economics of a business or finding a peripheral product that has more market demand.
But, at the end of the day, hitting upon a product that lots of people use at the right price point is out of a founders’ control. It’s called luck.
If you ask investors to pick the #1 criteria they look for in a company, many would say “team” or “market” (and obviously, there are many criteria that investors look at – not just one). Having seen so many companies with both great teams and awesome markets fail, my #1 criteria would be product-market fit.
There are a lot of great founders out there in the world and a lot of big markets, but there are not a lot of products that have product-market fit. I don’t want to bet on luck.
2. Speed is the best indicator of an awesome team
When investors say they are looking for “awesome teams,” I never understood what they meant. How do you know whether a team is awesome? (especially if you don’t have history with that team).
Referrals can be an OK vetting source, but having looked at a lot of companies this year from referrals, I’ve found that referrers have very different definitions of who are “awesome teams.” Plus, it can be hard to discern how strong the referral is.
I invest in accelerator companies to learn more about teams. What I’ve learned via the 500 Startups accelerator this year has above and beyond dominated my learnings from doing straight up angel or seed investments. When you do a seed deal, you put money in, and while you might get reports every once in a while, you never really know what exactly is happening at the company.
When teams come to our space in Mountain View, I get to learn in detail about how they think about their business, how they work together, and how they mobilize. I get to see everything – from the wins to the founder drama to seeing founders go through aha or learning-moments.
So who are the best teams? It turns out the best teams are not necessarily the oldest, the youngest, the most experienced, the best-credentialed, or even the smartest.
The best teams are the ones who move quickly; they are fast in all respects. They execute on short time frames – time to push product, time to learn, time to hire or fire, time to resolve founder-drama and morale-issues. They don’t let issues build up. They nip them in the bud. They tackle challenges head on and immediately. They are not afraid to ask questions to clarify what they don’t know and are very quick to learn and get help. How fast a team moves is the best indicator of the greatness of a team, and being quick also helps to extend a team’s runway and try lots of experiments to increase chances of getting to product-market fit.
3. Unit economics > Growth numbers
Although a lot of investors are all about growth growth growth, I’ve seen a ton of high growth companies with poor unit economics get stuck in the later stages of fundraising.
Surprise surprise! Profitability does matter at some point. If a company is losing more money by selling products than not, this is a very bad sign, even if your growth is phenomenal.
To an outsider not in venture-backed startups, this may sound like a ludicrous insight. Afterall, shouldn’t investors be looking at whether businesses are viable? This isn’t altogether obvious in the Silicon Valley. There’s a pervasive mentality that you should grow quickly so that you can be a winner who takes the whole market.
This is fodder for a much longer blog post, however, I think this “growth-at-the-expense-of-unit-economics” is really only beneficial to perhaps 5% of venture backed companies. If you are a business who needs everyone to be using your product in order for it to be valuable, then growing at the expense of unit economics makes sense. Think Uber. Think Facebook. But if you’re, say, a SaaS business or an ecommerce company, your 100th customer’s experience is really not any better because you overpaid for the first 99.
Tactical fundraising by Elizabeth Yin 