One of the most valuable pieces of advice given to me before I started professionally investing was to not push any deals in the first six months. Instead, take as many pitches as possible and try to parse the components of attractive companies.
Given that the average early stage investor sees about 1,000 companies per year, some trends should emerge after seeing 500 pitches; you begin to identify nuance outside of the typical advice of “good team”, “big market”, “defensibility”, etc. What are the specific signs of a good team? Is the market big today or big 10 years from now? Is the product defensible or is the marketing channel defensible or does the product become defensible over time - which one of these is most attractive?
Given meeting companies is a recurring event, investing time to develop and introduce an investment framework into the process quickly starts to pay dividends.
My investment framework has evolved over the last five years and I’m sure it will continue to evolve. The current criteria are detailed via six questions. Not all potential investments have a 'yes' answer to each question, but this framework serves as a mental (and sometimes physical!) guide to help me quickly sort companies into “this-is-not-a-fit-for-me” or “this-is-a-fit-for-me” buckets.
Before we get into the framework, let’s outline the venture “game”.
The Venture Game:
You’ve probably heard that venture is a power law distributed industry. Out of all startups in a year, only 10 will drive 95+% of the returns for that cohort. Here’s a clip of Mike Maples, seed-stage legend, outlining the concept in a 2016 Stanford presentation.
I’ve been in venture long enough to have some proprietary data to back this up. Below is a histogram of Canaan Beta investments. All initial investments were seed stage; the first investment was made in January 2018 and the most recent investment made in October 2021. Out of all investments, none have died so far and one has sold for a 7x return.
You can see the makings of a power law distribution. The top three investments make up 60+% of the returns and that percentage will only increase as the top three investments continue to execute and other investments fail. My expectation is that one investment will likely return at least 2-3x the fund.
This is a long detour, but it is an important long detour. One’s investment framework can only be successful if it’s mapped to the correct success metric. I believe if you’re playing the venture “game”, your success metric is to invest in one of the 10 companies that drives the bulk of the cohort’s returns, to pick the company with the extremely-large and world-changing future state. However, feedback loops in venture are long; it takes about 5-10 years to know if your investing was successful. That is why architecting an investment criteria correctly is so important.
As I mentioned above, my investment criteria is composed of six questions:
- What is the founder’s unique insight and why is it substantiated?
Founders need to know something that others don’t. That insight can be based on any prior experience - work, life, or otherwise. Founders should test their insight to see if it is “substantiated”. For example, Brian Chesky at Airbnb had the insight that people wanted to make money on unused space in their homes. He put an ad on Craigslist and received an overwhelming response in 24 hours - a substantiated insight.
Once an insight is substantiated, it is a glimmering of product-market fit, which can be further explored with pre-seed or seed capital.
- Can the founder effectively sell the mission/vision of the company?
Selling the mission/vision is core to the founder’s job. The founder needs to be able to succinctly and passionately explain why the opportunity is compelling almost as if she/he is telling a story. This skill isn’t just important for raising capital. It extends to all aspects of the company - building an exceptional product, hiring a 10x engineer, convincing an enterprise partnership to take a chance on a startup, and almost every other conversation a founder will have.
- Is the product market expansive or market creative? If the product is only market penetrative, is the market size big enough (i.e. in the trillions) such that a single digit penetration results in a massive outcome?
a. Market expansive is when a company leverages tech to lower the price of a product or service to broaden access to that product or service, ultimately expanding the market. An example is Robinhood eliminating trading fees to make equity/options trading accessible to anyone and at any scale.
b. Market creative is when a company takes advantage of an underlying platform shift to create a unique product and unique market that have never existed before. An example is Facebook used the internet to bring physical identity online and drive near-instant connectivity in order to make one of the world’s largest targeted ad networks.
c. Market penetrative is when a company makes a product or service to take share of an existing market. There might be new product features or a better product, but the penetrative company is not changing the ultimate market size. An example is Casper providing a better way to buy mattresses, but humans only need one mattress. Market size is fixed assuming mattress price is roughly the same.
Investing in market expansive/creative opportunities is core to venture investing. Why? Because the magical property of software is that the cost of servicing a marginal user is free. Leveraging that property, software can automate products/services to reduce cost and make the core product interoperable to provide a better ultimate experience. However, market expansive opportunities are often overlooked as investors seek big markets now without understanding what the market could be in the future with a product at a tenth the cost or a 10x better experience.
- Is the product magical?
Do you remember the first time you called an Uber? I clicked a button on my phone and a car showed up. I rode to my destination then I got out. That was a magical feeling. Admittedly, this criteria is a bit subjective. In many cases I’m not the consumer of the product. In that scenario, I have to seek out people that are the consumer to understand how magical the product is.
- What is the compounding advantage?
Have you come across a company that is growing so fast that it seemingly can’t be stopped? That growth is usually driven by a compounding advantage. I define a compounding advantage as each new user/customer bringing more marginal value than just that individual user/customer. With a compounding advantage, as a company adds users/customers, it becomes more defensible.
Classic examples of compounding advantages are network effects (virality), data moats (better targeting, pricing, etc.), brand (lower CAC), efficiencies of scale (better unit econ), etc.
- Why now?
If there is no inherent shift in underlying technology or user behavior AND there is a big opportunity, someone would have started it before. Or more perilously, will start it tomorrow. A clear and succinct answer to “why now” is necessary to understand whether you are going down a path where many others have failed.
During each pitch, I run through this checklist in my head, mentally noting question marks if I am unsure if one of the questions is satisfied. About 3-4 times per year, all six attributes will be immediately satisfied. For all other cases, this framework serves as a guide for my diligence.
Other Investors’ Frameworks:
While many investors shroud their investment framework, or worse don’t even have an investment framework (!!), there are a number of phenomenal investors that are public about what they look for when making an investment.
I have the advantage of building upon what the investing greats have done before me and can cherry pick characteristics that fit with my personality and risk profile.
Paul Graham, Y Combinator:
- Is the founder formidable, where a formidable founder is defined as “one who seems like they'll get what they want, regardless of whatever obstacles are in the way”?
- How big is the current or future market?
- Why now?
- Can the founder convince themselves of the large opportunity and in turn convince investors of the same (concisely)?
Sarah Guo, Greylock:
- Is the team passionate, unique, and one that I want to work with for a decade?
- Is the problem worth solving and does the team have a deep understanding of it?
- Does the product POV make sense to me?
Jess Lee, Sequoia:
- Does the founder have grit?
- Does the founder have a growth mindset?
- Is the market giant (or growing) and does the founder dream big?
- [Bonus!] Is the founder a good storyteller?
Mike Maples, Floodgate:
- Why now?
- What is the founder’s earned secret?
- Is it a networks-driven business?
Keith Rabois, Founders Fund:
- What is anomalous?
- What “secret” is the company predicated on?
- What could this be?
- Could this be one of the most important companies on the planet?
- What is the accumulating advantage?
- Can the founder attract the talent requisite to achieve the vision?
- Why do we have a comparative advantage?
Bijan Sabet, Spark:
- Are the founders extraordinary?
- Do I love the product?
- Is the vision compelling?
- If I wasn’t a VC, would I want to work for the founders at the startup?
USV Theses, Fred Wilson and Rebecca Kaden:
- [Fred on founders] Does the founder have charisma, technical expertise, and integrity?
- [Thesis 3.0] USV backs trusted brands that broaden access to knowledge, capital, and well-being by leveraging networks, platforms, and protocols.
My hope is for this essay to unshroud some of the mystery of why a VC might pass on a given investment and help founders spend their time more effectively with those that see the world in the same way.
1. Special thanks to Jared Newman and John Necef for editing.