Dave McClure of 500 Startups is a well known figure in the VC space, originally for his crazy use of text and colors in presentations and more so now for his fucking colorful language. He shared his investment thesis back in 2010. This is atypical in terms of thesis’ as it is more like a roadmap of how startups should build startups, and if they do that he wants to invest. He clear has his views and is able to share them.
MoneyBall for Startups: Invest BEFORE Product/Market Fit, Double-Down AFTER.
Investment thesis venture capital 500 startups
My apologies… this is a long piece (~2500 words). Not for the faint of heart. If you want the short story, read the abstract below & 3 core assertions, then cut to the conclusions at the bottom.
Abstract: VC funds are getting smaller (good), & angel investors are growing (also good), but both need to get smarter & innovate. Startup costs have come down dramatically in the last 5-10 years, and online distribution via Search, Social,Mobile platforms (aka Google, Facebook, Apple) have become mainstream consumer marketing channels. Meanwhile acquisitions are up, but deal sizes are down as mature companies buy startup companies ever earlier in their development cycle.
What does this mean? What opportunities/pitfalls does it present for investors?
Let’s start with 2 intial observations about the current market for investors, and for startups.
Assertion #1: Most consumer internet investors (angels, seed funds, big VCs) have no clue what the fuck they’re doing. Except for a few brand names, most large funds >$150-250M will die in the next 3-5 years… and that’s a good thing. Still, smaller investors will need to innovate and differentiate in order to attract proprietary, quality dealflow and survive.
Recently some very smart folks have been talking about the relative [upside/downside] of being a [small/big] investor in tech, and specifically the changes & challenges going on in venture capital in the last decade. Due to reductions in CapX rqmts & median exit size, it’s tough to be a large fund (say, over $250M?) that invests in consumer internet. However, while i agree there is a Moneyball “small-ball-is-beautiful-baby” story going on in venture, that summary is too concise… and it misses a more significant point re: differentiation in investor domain expertise & services (or lack thereof), and the importance of staging follow-on investment based on product/market maturity (more on that later).
IMHO, whether or not your fund is large or small is not the primary issue in consumer internet investing. While my biased belief is $10M-100M seed funds are a lot easier to manage & more entrepreneur-aligned than “traditional” $250-500M+ funds, there will likely be a few winners and LOTS of losers at both ends of the spectrum. Probably more BIG fund losers than small fund losers, but still there are many other factors than fund size that will predict for success or failure.
No, the primary issue is that investors of all shapes and sizes have become incredibly lazy and complacent over the past two decades, measured by both activity and by IRR. Meanwhile, the consumer internet has brought a tsunami of technological & behavioral change which has resulted in stunning reductions in time & cost needed to distribute products and services to the over 2-3B connected people on the planet.
Let’s examine that more closely:
The INTERNET has changed life DRAMATICALLY for BILLIONS around the globe — yet most VCs & lawyers still close deals via fax & snail mail.
Fuck. That. Noise.
Most consumer internet investors, large or small, have no goddamn clue what they are doing. They are getting killed on IRR, and most of them should be put down & put out of their misery… NOW. Their investment thesis is suspect, their domain-specific skills are limited or non-existent, and their desire & ability to innovate is minimal. They are simply collecting fees, waiting for the next tee time.
Well ATTENTION K-MART SHOPPERS — you, Mister VC 1.0, are about to be DECIMATED… and it’s a Schumpeterian Fate that is both deserved and overdue.
HURRY UP & DIE ALREADY, U FRIGGIN’ PATHETIC DINOSAURS.
Indeed: most VCs are Dinosaurs, and the World Wide Web is an Asteroid that hit the planet in a slow-motion cataclysmic explosion 15 years ago. It may take another 5 years for the ash clouds & nuclear winter of Browsers, Search Engines, Social Networks, & Mobile Devices to kill all the T-Rexes, but it’s a done deal. The marsupials are taking over and in 2015 there will be a lot more investors that look like Jeff Clavier, First Round Capital, Y-Combinator,TechStars, Betaworks, & Founder Collective than any Sand Hill VC (funny how all the innovation is from non-valley investors, isn’t it?).
Now let’s take a look at changes that have occurred, & how to adapt as a Lean Investor 2.0:
Assertion #2: There is tremendous opportunity in building revenue-focused consumer internet startups for $1-5M that a) attain some level of commercial viability, b) acquire customers predictably using online distribution channels (Search, Social, Mobile), and c) can later be sold for $25-$250M.
Historically, Venture Capital has been about the use of large, risky, CapX spending to accomplish two primary & typically expensive goals:
1) Build Product.
2) Acquire Customers.
Now in the past, PRODUCT has meant building a variety of expensive things (big iron, disk drives, personal computers, packaged software, computer chips, designer drugs, network routers, browsers, search engines, social networks, etc) with lots of people over periods of years. We’re talking 50-100+ people spending 3-7 years building shit, with no offsetting revenue for quite some time. That’s a lot of headcount and expense before you even get to your first customer.
And to make that even worse, many of the VC-funded startup companies target CUSTOMERS have been large, enterprise companies in tech and/or government entities with looooooong sales cycles requiring expensive, direct, dedicated sales force… that also cost shitloads of time & money. Or large mass-marketing sales & marketing campaigns conducted via expensive print, radio, & television marketing. And the sales cycle was annual, requiring ongoing efforts to hit quarterly or annual sales targets via license revenue and maintenance support and upgrades.
Finally, many of these companies were being built/financed to go public over a series of many years and multiple capital raises where the amount of ownership by the entrepreneur was quite small (usually single-digit %’s) and the target exits were huge, hundred-million if not billion-dollar outcomes.
Fast Forward to Twenty-Ten, and let’s take a look at these fundamentals, with a specific lens on the consumer market & internet startups:
- PRODUCT now typically means a website or service, run on low-/no-cost open source software, hosted in the cloud on low-cost servers, developed in a few months (or a WEEKEND!) by a small team of 1-5 developers, who continuously test & iterate in real-time with online customers
- MARKETing now typically means using a variety of online distribution channels via paid & organic search (SEM/SEO) on Google, viral/social amplification on new media platforms & social networks like Facebook, Twitter, & YouTube, and the quickly-growing mobile platforms of Apple iPhone & Google Android. With the exception of search, most of these distribution channels didn’t exist 5 years ago, yet they now easily reach over 100M-500M+ users, with very low cost and measurable marketing campaigns such that even a small team can reach billions of people globally.
- REVENUE can now be collected easily via a variety of online payment, transactional e-commerce, digital goods, subscription billing, lead generation, CPM/CPC/CPA advertising. Many people buy things online now, and many companies are even bought for usage & users ahead of revenue. In other words: Brothers Are Gettin’ Paid, Yo. Cash Money, G. It’s aaaaalll goooooood, mah nizzle.
So to summarize: PRODUCT development cycles are shorter, required materials & resources are free or low-cost, development teams are smaller, and new services mashup & build on top of old services that already deliver terrific value in the cloud via features, data, network effects, & APIs. MARKETing costs are lower, due to a variety of broadly-available, low-cost, online distribution channels, which can be used in more measurable and predictable ways than ever before. high-bandwidth to the home means video and other data-intensive media are commonly available to anyone with cable or satellite TV. REVENUEcan be generated simply & continuously, via direct business models & online payment methods that are becoming mainstream all over the world… such as mobile payments even in the remotest, poorest economies.
Finally, as more tech & internet companies mature and become profitable, they in turn are a larger source of exits & liquidity as they attempt to acquire startups with innovative technology & desirable products & services. By utilizing their larger customer base as a way to leverage distribution, they can acquire smaller companies who want low-cost ways to access new customers. However, as more of these companies mature & compete for acquisitions, many startups are getting bought up earlier in their lifecycle at smaller dollar amounts than if they had to grow to IPO-required size. And as even non-technology companies attempt to acquire innovation & expertise in online services, more but smaller exits is a likely ongoing trend.
Okay, so that’s a lot of crystal-ball gazing into the near-future, but now let’s take a look at some emerging best practices & fundamentals for investing in Consumer Internet startups.
Assertion #3: Startup investment can be staged in 3 distinct phases with explicit goals & outcomes:
1) PRODUCT = Customer Problem/Solution Discovery (MVP), User Experience / Usability
2) MARKET = Market Sizing, Campaign Testing, Customer Acquisition Cost(s) & Conversion
3) REVENUE = Expand Revenue and/or Market Share, Optimize for *PROFITABLE* Revenue.
Largely, this is about applying techniques in Customer Development (Steve Blank) and The Lean Startup (Eric Ries) to investing, and in particular how to research, improve, & identify Product/Market Fit (Sean Ellis, Marc Andreesen), otherwise known as “TRACTION”, before and after you invest.
This is really the key to my investment thesis: Invest BEFORE product/market fit, measure/test to see if the team is finding it, and if so, then exercise your pro-rata follow-on investment opportunity AFTER they have achieved product/market fit. It’s sort of like counting cards at the blackjack table while betting low, then when you’re more than halfway thru the deck and you see it’s loaded with face cards & tens, then you start increasing your betting & doubling-down.
Let’s face it — most venture investors are sheep. We like unfair advantages. We want to know that there is already customers, revenue, and that elusive thing called TRACTION. Unfortunately, if it’s obvious that there is already customers, revenue, and TRACTION then there will likely be a LOT of other investors at the trough, the competition will be fierce, and as a result the price to invest will be high.
So how can you invest at low-cost, then figure out when to follow-on to increase your value?
it’s pretty simple, actually.
INVEST EARLY at LOW COST in people you think are smart and have built some promising products. understand if they know how to iterate and use customer feedback to improve their product and/or marketing. learn how to understand conversion metrics for their business & customer value.
then IF you see the metrics improving & customer / business value increasing… then DOUBLE-DOWN.
however this happens in 3 distinct stages:
1) PRODUCT: Discover a [large enough] customer segment with a meaningful problem / strong desire, and develop a functional solution for them to use (Minimum Viable Product aka MVP). I also call this when ACTIVATION happens. You should also make sure the user experience is compelling enough for them to use it more than once (RETENTION).
2) MARKET: Test for scalable distribution channels that allow you to acquire large # of customers at cost less than what you will generate (ideally, at <20-50% of annual revenue so you have some cushion). You may also find you have to go back to #1 and change some things, or discover entirely different marketing campaigns & concepts to get to scale. If you’re lucky you may even discover a way to get your users to spread the word for you (word-of-mouth and/or viral features).
3) REVENUE: hopefully your MVP is already obviously valuable enough that people will pay something non-zero for it. regardless, the goal is to test & optimize for product/market(ing) combinations that generate cash-flow positive outcomes at scale, over short periods of time (or longer periods if you have financing structure to merit). i tend to prefer business models with low complexity, such as direct transactional or e-commerce models, subscription billing models, or lead-gen / affiliate models.
Ideally you’d like to be able to invest in a functional product AFTER the entrepreneur has already got it working, but sometimes they aren’t there yet, and often they will have to pivot regardless in order to find an interesting segment that scales & is profitable. Still, i’d like to think most entrepreneurs who understand their customer can build a functional MVP in 3-6 months, for <$100K. Sometimes it takes longer / more capital, but most times it doesn’t. If they look like they figure it out, double-down.
Next, you’d like to be able to improve the user experience and engagement / retention, get them to increase their love for the product. If you can do this well enough, your customers will become your marketing… at very low cost. Even if you can’t get to strong word-of-mouth or viral marketing, you can still hopefully reduce customer acquisition cost by getting incremental social amplification. Regardless, your job is to discover SOME kind of scalable distribution channel that seems like it COULD be optimized to a point where it’s cash-flow positive at some point in the future. Hopefully this doesn’t take more than $1-2M and 6-12 months to figure out. But most of this spend should be on MARKETING channels & testing, NOT on adding more features… you can pivot to discover new customer use cases, but DO NOT keep adding features. in fact, you might want to remove them (see KILL A FEATURE). If it looks like you’ve got scalable distribution, even if not quite break-even, then double-down.
Finally, now that you have functional product (hopefully AWESOME product with strong activation / retention / referral metrics), and you have some ideas on scalable distribution that converts to non-zero revenue events (or proxy events such as long usage or referral / affiliate / lead-gen behavior, advertising CPM/CPC/CPA), now you need to tune to get to profitability within some finite period of time that you can finance and/or stretch to achieve. This is where it can sometimes get quite expensive, and it could take years to get to profitability for some businesses, but I’d like to think that my startups can figure this out in $1-5M and 1-2 years. Again, if it looks like you can get there, then double-down.
In summary, you should be thinking about stages for risk-reduction & company value creation that look like this:
1) Product: $0-100K, 3-6 months to develop basic MVP that’s functional & useful for at least a few customers. Get to small product/market fit.
2) Market: $100K-$2M, 6-12 months to test marketing & distribution channels, understand scalability & customer acquisition cost, conversion to some non-zero revenue event. Get to large product/market fit.
3) Revenue: $1-5M, 6-24 months to optimize product/market fit and get to cash-flow positive.
I might edit this a little bit, as I’m in a rush to finish publishing and get back to other projects, but I think this has captured most of what I wanted to say for now.
Appreciate feedback & commentary on anything that doesn’t make sense, could be improved or can be streamlined.
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Also published on Medium.