An Imprecise and Idiosyncratic Framework For Deciding When To Invest
People often ask about our “investment thesis” or our “sector focus”. There are moments when I am tempted to make up something akin to what most of the big funds have. But it’s much less rigid and more idiosyncratic than that.
Both through funds in the Northwest and directly, we participate in pre-seed and seed rounds. I probably talk to about 100 companies each year. We regularly look at a broader spectrum of deals. These thoughts are based on that perspective.
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I believe that a venture pitch is a four act play. Act 1 always describes a big opportunity–a problem begging to be solved. Act 2 is about why that founder’s approach is unique and likely to succeed. This may involve positioning. versus the status quo or competitive options. Act 3 is where the reasons to believe are presented. This can include market traction, indications of interest from customers or partners, past success or technical innovation. Finally, Act 4 is the happy ending. Why should we believe that every dollar that we invest has the potential to come back as five or ten dollars.
We suggest that founders stick to this framework whether they have two minutes in the proverbial elevator or two hours in a conference room.
While I do not have an algorithm, this four act framework translates into a four part evaluation structure:
- Opportunity
- Approach
- Execution
- Outcome
Jim Lanzone, currently CEO of Yahoo, worked for me at IAC. He had an expression that that has always stuck with me “I’d rather have a slice of a watermelon than a whole grape”. That’s the essence of the Opportunity section. There are lots of very good small businesses that can provide someone with a good living. But a venture-backable business needs to have a watermelon-sized opportunity. Businesses with scale have a higher likelihood of being acquired and providing a return. And, while there is often more competition in big segments, there is also more upside. The size of the opportunity builds forgiveness into the model.
One of my business school professors said something else that has stuck for more than forty years– “dollars make markets not bodies”. An opportunity needs to be expressed in currency. But it’s not enough to say that there is a multi-billion dollar market. You need to describe a specific problem within that market that is real and demanding to be solved. And you need to convince us that people are willing to pay money to solve it.
How you are going to solve the problem is the core of the Approach section. How are you going to solve the market’s problem in a way that the incumbents have not and other startups cannot. This needs to be crystal clear and action-oriented.
Most startups fail. Most VC investments return zero. The Execution section needs to tell me why I should believe that you are the team that will be successful. This can include everything from market research to early sales to letters of interest to patents. It can also showcase the skills and past success of the team members. You can’t always have all the key team members onboard at an early stage, but missing important executives significantly increases the risk.
When we discuss Execution with founders, we like to get a sense of their operating dashboard. What are the most important metrics? What do you believe you will need to prove in order to raise a future round? Startups often fail because of lack of focus. As Pogo said they are “crushed by insurmountable opportunity”. Too many ideas. Too little time and money.
That is why it is important to talk about cash management during the Execution discussion. Money is always harder to come by than you expect it to be. I ask myself how confident I am that this team with this story can raise the next round. We sometimes (and with regret) walk away from investing in good teams with good product ideas because we don’t believe they can raise additional capital. I feel bad saying that but it’s a reality of early stage investing. Often it is because of trends and prejudices among VCs. Some categories of are on a “no fly” list. Companies with good ideas and good teams run out of cash every day.
It’s easy (but not persuasive) for a founder to speak as if everything will always be rainbows and unicorns. If that’s your expectation, and the basis of your plan, you’re bound for disappointment. It’s better to be honest about where the tough parts of the plan are and build in time and cash to make the necessary course corrections. There’s an old sports expression saying “Good teams find a way to win. Bad teams find a way to lose”. That’s absolutely true in startups. Things never go according to plan. Successful teams adapt, improvise and overcome. We look for that ability early in the process.
Part of your extended “team” are your investors. In the earliest days these are likely to be truly friends and family. While every dollar is green, it is often worth the effort to add respected investors to the early rounds. As a startup advances, the investors on the cap table become an important source of validation and as well as a pathway to future investors.
Finally, we need to believe that there can be a good Outcome in a reasonable period of time. Early stage investing is inherently a long game. I have been involved with some of my best companies for ten to fifteen years. We don’t expect a founder to be able to say that Google or someone else with buy them on July 1, 2026. But we like to have a sense of what an exit might look like.
At the end of these conversations, I ask myself “what do I need to believe to write this check”. These two or three necessary beliefs are different for every deal. There can never be absolute certainty in early stage investing but I (and other investors) need to have sufficient confidence.
It would be great if we could write a Chat GPT prompt that would perfectly and bloodlessly score investment opportunities. But it doesn’t work like that. It’s an organic, messy process. But most often, it comes down to the people across the table from you.
ABOUT THE TITLE IMAGE: Borrowing an idea from my friend, Brad Berens, I asked DALL-E to create an abstract image based on the full text of the article. I like it a lot