Category: Investing

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.)

Here are just a couple of data points:

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

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.

Cover photo by Patrick Tomasso on Unsplash

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 about perseverance, grit, tenacity?]

Customers and traction

• Do they have product or market fit? [Get more specific – what questions would you ask to figure this out?]
• Do they have customers? How many?
• Who exactly is the customer?
• Are they paying? If so how much?
• How frequently are customers buying or using? [Or churning]
• How much does it cost to get a customer?
• What is a customer worth? [lifetime value]
• [How much revenue are you making and how has this changed over the last few months? What are your margins?]
• [How are they getting customers?  What customer acquisition channels have they tried or not tried ?]
• [Is this growing? How quickly?]

Market

• 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]

Other

• 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.

Unit economics for the win.