Hi! Thanks for joining me, Dave Edwards, for this week’s Metrician, a newsletter with insights on modern startup finance and the metrics that matter. If you haven’t signed up yet, you can do that here. Feel free to respond via email with any thoughts you’d like to share and check out more about what we do at X Foundry here.
When I made my first venture investment in early 2000 as a partner at Charles River Ventures, the company taking the investment had a few founders, an interesting idea and a bit of progress, but certainly no revenue. That was good enough in those days to raise a couple of million dollars through a Series A investment. Today, though, things are different and much harder for early stage entrepreneurs.
Despite an astounding amount of capital chasing privately-held growth companies, funding for truly early stage companies is harder and harder to come by. I regularly find seed stage venture firms which require companies to have revenue to be considered for an investment. I even came across a “pre-seed” investment firm that requires a company to have $5,000-$30,000 in gross profit per month.
If seed and pre-seed investors require companies to have revenue, how can entrepreneurs finance building a company before there is revenue? And why are investors avoiding making early stage bets?
I think there are three things going on:
Too much capital. The investment world is flush with cheap capital due to more than a decade of low interest rates and steady economic growth. This increase in capital availability has led venture funds to increase their money under management (and their management fees). In order for the firms to invest more capital, though, they have three options:
each partner needs to make more investments (increasing their workload)
the firm needs to add new partners (sharing the economic rewards across a larger group)
the firm needs to increase the amount invested in each company (bingo!)
The last option is optimal for the existing partners: more money per investment means more money under management per partner which means more management fee per partner—making the best job in the world even better.
Investing more money per company is a lot easier to do if you skip the early stage companies that don’t need much money.
Disconnection from reality. There’s a theory in the venture community that great entrepreneurs will be able to bootstrap their companies to prove product-market fit before raising capital. This works if the founding team has the financial capability to work with no pay for months or years and/or if they have “friends and family” with the capital and risk appetite to back them.
One of the issues of staffing venture firms with those who are already successful and wealthy is that they mostly hang out with other people who are already successful and wealthy. Their immediate social circle encourages the idea that entrepreneurs can afford to bootstrap their own companies. And their social circle can provide plenty of leads for new investments started by entrepreneurs who are already successful and wealthy.
Backing the previously successful and wealthy may be a great investment strategy but it leaves out the rest of the world—which may include the next great founding team.
Laziness. One of Silicon Valley’s most prominent venture capitalists recently said to me, “most venture investors follow the herd because they’re incredibly lazy.” While he was being a bit harsh, he has a point.
Understanding opportunity once a company has proven product-market fit takes a lot less work than understanding opportunity when it is at idea-stage. And, given that part of the dynamic of investing is to limit risk while maximizing returns, it makes sense that venture capitalists would rather invest in a company that has proven product market fit than one that hasn’t yet. Does that increase the likelihood of better returns? For some, yes.
Does that make them lazy? Perhaps. I wouldn’t describe most of the venture investors I know as lazy. But most of them are biased toward companies with proven ideas and founders they already know. This makes good economic sense because it lowers their risk. But it keeps their capital close to home. As a contrast, it’s great to see the growth of early stage investing outside of Silicon Valley like the Bend Venture Conference (see below). We're excited by this trend and think it will open up a lot of great opportunities for new companies and new investors.
Investing is about making money. And sometimes making money means going for the easier wins of proven ideas with previously successful founders rather than not-yet-proven ideas with not-yet-successful founders.
I personally like working with founders starting at the idea stage. Yes, it’s a lot more work and there’s a lot more failure potential. But it’s also exciting and rewarding to help someone develop an idea into a company—especially when it’s their first time.
What should entrepreneurs do?
Do as much planning and research as possible before talking with investors. When seeking an investment, it’s important to be able to show why you’re worth investing in. Once your company is operating, you’ll be able to say: look at our customer growth, look at our unit economics, look at our sales pipeline. But at the earliest stages, you can only say: look at the proof we have about why this is a good idea.
You’ll want: crisp definitions of the market problem and how your solution resolves it, deep knowledge of the user journey and experience, clear understanding of the current competitive environment, detailed calculations of unit economics and the overall business model and a well-thought-out go-to-market plan. While this won’t ensure success, it sure helps increase investor’s confidence in your idea and in you as an entrepreneur.
Want help with this? Get in touch.
What about investors?
We encourage investors who like early stage investing to make small bets on the ideas that they like best (and will likely want to work on) with a community that can support the entrepreneur. This is the model that angel groups pioneered and has now been institutionalized through accelerators. Pooling effort and expertise along with capital is the best way to help entrepreneurs (and your investments) succeed.
We’re experimenting with a “virtual accelerator” model where we can bring virtual teams together to support entrepreneurs through different stages of growth. While nothing can replace in-person connections, most entrepreneurs can’t uproot themselves to co-locate with an accelerator. And most entrepreneurs don’t have all of the advice and support they need in their local communities. By tapping a virtual team, we can tap into a bigger pool of resources and help a larger group of entrepreneurs be successful.
At the moment we’re working with an app company with an innovative approach to helping millennials find jobs, a new mindfulness app with a media star founder, a new home care marketplace, an AI company that finds truth in the internet, an AI-based security technology, a new women-focused sports clothing brand and a new device for early breast cancer detection. These companies range from close by in Oregon to as far away as LA, NYC, Florida, London and Sweden. We use a modern technology stack to keep connected and to include support teams from around the world: branding in Europe, technology in South America, finance in Colorado.
If you’re interested in this idea as either an investor or entrepreneur, let me know. We’d love for you join us and help pollinate new companies.
Also this week:
Direct listings. The FT reported this week that the SEC met with Morgan Stanley, NASDAQ and Latham and Watkins to discuss alternatives to IPOs as a method for companies to raise capital and list on the public markets. L&W has been pursuing options for companies to raise capital in the private markets just prior to a direct listing so this may be what they talked about. But there may be other options as well. I wasn’t sure how well direct listings would work (expressing caution about both Spotify and Slack) but given how well the process ended up working, I’m really encouraged to see the banks and lawyers pursue new processes.
Bend Venture Conference. We attended the 16th annual Bend Venture Conference and saw a bunch of really interesting companies pitch investors. The winners were:
Riff Cold Brewed (Bend OR) which creates an all natural energy drink using coffee fruit—the berry part of the coffee plant that is usually thrown away, creating an environmental mess. The economic upside for coffee growers and the positive environmental impact both seem compelling. The team includes some very accomplished beverage people. And the drink tastes good! Supposedly, it’s even better with tequila.
FleetNurse (Eugene OR), an app-based on-demand nurse staffing solution for hospitals and other care facilities. We’ve been doing some work in the home care space recently so have some good familiarity with niche-focused staffing opportunities. And we think these can be great businesses.
Observa (Seattle WA) combines crowdsourced images with AI to provide brands with real-time insights into what’s happening with their products in retail including product availability, pricing and promotions. Given our strong interest in AI solutions (see Sonder Scheme), we understand the complexity of what they’re building and think this is an innovative approach.
Belmont (Portland OR) provides break-room managed services - break room as a service or BRaaS. It’s a system for making sure your company’s break-room has the products your people want in stock and on budget. Given the trend toward providing great workplace experiences, we think this one has good opportunity. And they’ve already proven some traction with companies in the Portland OR area. There are competitive services out there but there’s good M&A/roll-up opportunity which would value Belmont for its contracts, if not for its technology.
Thanks for your time. If you think a friend might enjoy this newsletter, please forward it along. You can follow me on Twitter at @dedwards93 or email me at dave@xfoundry.io.