The only way to raise money: Make them believe

Ignore what you’re reading about the current investment climate.  Yep, there is plenty of VC money out there and it’s aggressively looking for a home.  But that doesn’t mean it’s so much easier to raise money than in prior years.  The number of startups vying for those dollars is greater than ever.  With so much noise in the market and so many companies in which VCs can invest their cash, raising money is still about the one thing it’s always been about: making a VC believe.

There are many perceived reasons for why VCs make investment decisions.  But the reality is that it’s actually emotion that leads most VCs to invest.  A VC only invests when she finds a quality in a startup that touches upon something personally meaningful or important to her; a quality that creates an irrational belief in the startup’s ability to succeed.  I refer to this feeling as “emotional resonance”.  There are only three qualities that enable a startup to create emotional resonance with an investor.  If you don’t create “belief” based on one of these things, take your pitch and go home because there’s no term sheet coming your way.

People: The best way of creating emotional resonance is through your team.  Despite popular opinion, VCs are people too!  Just like entrepreneurs and employees, they also want to surround themselves with people they love to work with and can learn from.  They want to support founders who they deeply feel deserve tremendous success or who compel them to believe in the likelihood of their success.  Belief might spring from any number of team characteristics, including the team’s story, chemistry or insights.  Given this, it’s no surprise that most VCs will tell you that they invest in people first.  And that’s true.  It’s the emotional connection to those people that leads to the investment.

Potential: The second way of building an emotional connection is via the potential of your business.  The potential might be captured by the mission or the market opportunity or the product.  But somehow you need to leave the VC feeling that he or she absolutely wants the problem you’ve identified to be solved or what you’re doing to exist in the world and that it will be big.  This is why VCs have a hard time investing in products and companies that aren’t targeted towards them.  Something that’s not relatable is impossible to connect with emotionally.  It’s the promise of an early stage startup that can help a VC make the emotional decision to ignore the difficult reality that most startups fail.

Proof: If you’re an early stage company, you don’t have it.  Move on.

So have only one goal in your pitch to VCs.  Make them believe.  Create emotional resonance with your people or your potential.  If your story doesn’t do that, rework it so that you focus on establishing one of those connections.  Present the opportunity in a way that reinforces the excellence of the team or the enormity of your potential.  Because the only path to a VC’s money is still through emotion.

No surprises: The key to the founder/VC relationship and avoiding the “Oh shit” board meeting

In the VC business, there is a running joke about the “Oh shit” board meeting – the first one that takes place after an investment has been made.  That’s when all of the bad news that was hidden during the diligence process gets uncovered and the VC is faced with the reality of the business for the first time (and the founders are faced with the reality of the partner they just “married”!)  At Homebrew, when we partner with a startup in support of the founders’ vision, we expect to share in the good, the bad and the ugly.  And we expect to share in it well before we invest.  After all, startups aren’t all rainbows and unicorns (see what I did there? :) ).  Bad hires get made, product releases fall flat and revenue doesn’t materialize.  These challenges are not the exception, they are the rule, particularly at the seed stage.  So we believe that the key to successful relationships between founders and their VCs is one simple rule: No Surprises.  And the application of that rule starts well before a formal partnership is formed between VCs and a founding team.

Accordingly, when we evaluate potential investment opportunities at Homebrew, we try to make the diligence process beyond the first meeting feel like a series of working sessions, which in part help expose potential surprises for both sides.  We find that this approach provides us with both a better understanding of how the founders think and a deeper appreciation for the nuances of the business.  Most importantly, it helps both sides get a feel for what it would be like to work together.  In these sessions, we tend to be pretty open and direct about what we find compelling and concerning about the startup.  We ask the entrepreneurs to be equally honest about not just their business, but also about the possibility of working with us.  What questions or concerns do they have?  What kind of help are they seeking from investors?  Are they concerned about forming a board and having board meetings?  Nothing is off limits in those sessions, because the last thing we want is for either side to go into a long-term relationship based on misinformation or misaligned expectations. We build the relationship on No Surprises.

On an ongoing basis, information needs to be shared openly and in a timely manner.  As major investors in your company, it’s failure if we’re hearing significant news for the first time in a monthly email update or at a board meeting.  No Surprises means that everyone has the same information at the same time so that they can react as a cohesive team.  And the No Surprises rule should apply to both sides.  Entrepreneurs should never be surprised by their VC, whether it’s related to personnel, business metrics, follow-on decisions or anything else. Trust is fundamental in startups, but it’s possibly even more important in an effectively permanent founder/VC relationship.  And living by the No Surprises rule helps keep that foundation of trust pristine.

So do yourself a favor when talking to investors.  Establish the No Surprises rule for both sides.  You’ll avoid the “Oh shit” board meeting and have a great long-term partnership as a result.

Homebrew’s investment interests: Local Marketplaces

Local offline-to-online marketplaces are just beginning to impact the lives of individuals and small businesses, enabling them to save time and money and generate new revenue streams.  Where there was previously friction, opacity or scarcity, local marketplaces are providing convenience, transparency and abundance.  Homebrew is focused on supporting seed stage companies like these that are building the Bottom Up Economy.  Our prior experience working with and investing in companies such as OpenTable, Angie’s List and several less successful marketplaces has helped inform how we evaluate and support investments in this segment.  Here are some of the other key things we look for in startups employing a local marketplace model.

Focused use case: We believe that scale is the outgrowth of doing one thing really well. Accordingly, we prefer to see local marketplaces that nail a specific, focused use case rather than take a broad platform approach from the outset.  Homejoy is a great example of a company that has had relentless focus on a single use case, cleaning your home.  An early competitor, Exec, offered a platform where all kinds of services, including home cleaning, could be requested but suffered as a result.  One of the primary benefits of focusing on a narrow use case is that customers don’t need to think about how or why to use the marketplace.  Focus makes that abundantly clear.

Premium experience for sub-premium price: Great local marketplaces enable customers to have a new experience that is magnitudes better than the old. But the best marketplaces deliver that new, better (i.e., premium) experience for a sub-premium price.  Uber and Lyft are the prime examples of delivering infinitely better experiences than hailing taxis and typically at only modestly greater costs (even cheaper in an increasing number of cases).  One of our Homebrew family companies, Shyp, is similar in that it delivers an incredible shipping experience at standard retail rates.

Necessities over luxuries: There are local marketplaces for all kinds of products and services, but we prefer marketplaces that are focused on necessities rather than luxuries. Necessities tend to have higher transaction frequency, greater word-of-mouth and less susceptibility to economic downturns.  Everyone needs to eat, wash their clothes and get to work.  But not everyone needs to fly in a private jet, rent a yacht or hire a Michelin star-winning chef.  Those can be wonderful services and they can be delivered in compelling ways, but our view is that products and services that are truly need-based lead to more vibrant. liquid marketplaces.

Organic distribution: Word of mouth is the best marketing.  But there are other forms of organic distribution that can be just as powerful and cost effective.  For example, when Uber launched, taking a ride with a friend introduced many others to the experience.  When Shyp sends a package, the recipient is exposed to the delightfulness of the service.  Many of the most compelling local marketplaces have dynamics where the same person can be both customer and supplier over time.  Dog owners on DogVacay can be hosts in one transaction and customers in the next.  We love to see marketplaces that have these types of organic distribution opportunities embedded in their services.

Few emerging replacements: While we always tell startups not to fixate on competitors, in today’s world where switching costs and barriers to entry are often low, we prefer to invest in local marketplace startups that are solving problems that few others are addressing with new solutions.  For example, for better or worse, we’ve avoided investments in the various types of food delivery companies because while frequency is high, there are many replacement products available.  This makes it hard to to acquire customers cost effectively, to protect margins and to maintain significant market share over the long term.  Many markets have room for more than one “winner” but very few have room for more than two or three.

The above characteristics may be unique to Homebrew, but we also like to see things that others have recognized as important to marketplace businesses.  Many of these are well-documented by Bill Gurley in his excellent posts on marketplaces and platform transaction fees.  In the past year, we’ve seen local marketplace startups in countless areas, including tech support, parking, home services, cleaning, laundry, food, labor, property rental and transportation.  We’ve made investments in several verticals, including shipping with Shyp, legal services with UpCounsel and property management with an unannounced investment.  But we believe that there are many more use cases for which compelling products and services can be delivered via a marketplace model.  If you’re starting a local marketplace company, especially in specific labor verticals or providing B2B services, please contact me at satya at homebrew.co.

Additional posts on Homebrew investment themes:

Bottom Up Economy

Vertical Software

 

Homebrew’s investment interests: Vertical software

Homebrew’s first fund focuses on what we’re calling the “Bottom Up Economy.”  The Bottom Up Economy thesis states that as technology becomes more affordable, flexible and accessible, many industries that have not benefitted from or been impacted by technology historically will finally do so  Software is eating the world in many cases but also enabling the world in others.  Accordingly, we spend a great deal of time getting to know entrepreneurs and companies building software solutions that disrupt industries or enable the existing industry players to compete more effectively.  And we’ve already invested in companies serving several different areas, including legal services, mental health, logistics, communications, financial services and commercial construction.  Given our focus on vertically oriented software, I wanted to share a little bit about the attributes we like to see in those startups.

Teams with a unique POV: As my partner, Hunter Walk, has written, we’re excited by teams that aredisrupting industries with love (and just enough greed :) ).  Teams that have experience in the domain tend to have a strong POV about what’s broken and how to fix it.  But often times the most unique insight can come from teams outside of their target industry who are approaching things with fresh eyes.  So we prefer to work with teams that can demonstrate domain expertise without the stagnation of assuming status quo is just the “way things are done”.  What’s critical is that the teams we invest in have an insight that many others either have not seen or don’t agree with.

Distribution focus: We tend not to invest in software companies that are 100% dependent on selling into theC-level via a direct salesforce.  Instead, we prefer a bottom-up entry point via individuals or teams within the enterprise or small business.  The startups that intrigue us have a well-articulated plan for how to get distribution of their software in the industry they are targeting, and most often that includes a strong likelihood for organic or viral growth. No matter how slick and easy-to-use your software is,if you build it they probably won’t come.

Long-term advantage: Nearly all software is replicable, so we look for companies that are likely to have long-term differentiation, ideally via customer or data network effects.  Network effects mean that the value of the software grows as more people use it either because it allows them to interact with more people in the context of their work or it helps collect and aggregate data that informs and improves their work.  The strongest network effects enable customers to benefit from product usage that occurs even outside of their companies (i.e. industry-wide).

Acute pain: VCs are notorious for categorizing things as an aspirin versus a vitamin or need-to-have versus nice-to-have.  But there is a good reason for this.  Unless software is helping addressing an acute pain or delivering value that can’t be ignored, it likely can’t attract the attention it needs to be used or purchased given the limited time of people and budgets of companies.  We like to see software that is addressing what is likely to be one of the top 3 hair-on-fire issues.  This kind of software has a better chance of drawing attention and dollars.

Widespread pain: In addition to the pain being acute, the pain needs to be felt by a lot of people.  This is important because companies need to be able to reach “venture scale”, usage and revenue that allows for a company to be valued many times higher than the value at which a VC firm invests.  For Homebrew, our goal is to invest in companies where we can see a path to returning the value of our entire fund ($35 million) from an investment in that company.  Both the total dollars invested and the price of investment have an impact on that math, but it generally means that we need to believe that the company can eventually generate $100 million in annual revenue.  That kind of scale requires a widespread feeling of acute pain.

Painless path to first dollar: It’s obviously easier to get someone to use something that is free than it is to get him or her to pay for something.  So we like to see products that are likely to have a painless path to the first dollar payment.  It becomes much easier to extract more economic value once the customer is convinced to pay for something because at that point she clearly sees some value in the product that is greater than what she is paying.  This typically means that there is a single person who has three characteristics: 1) she feels the acute pain personally 2) she has the budget needed to buy (can just put it on her company credit card) and 3) she can pilot the product easily (self-service sign-up, no IT involvement).

While we don’t have hard and fast rules or a checklist approach to evaluating investments, we always think about the criteria above when looking at opportunities in vertical software.  If you’re taking a vertically focused approach and have a story to tell that fits with our preferences and approach, don’t hesitate to get introduced to us or to reach out directly.

Trust and shared goals in startups

Of the many wonderful things about starting Homebrew, possibly the most satisfying has been working with a partner, Hunter Walk, in whom I have absolute trust.  That trust stems from a longstanding relationship, a commitment to helping each other be successful and a shared vision for what we want Homebrew to be.  And it makes it possible for work to rarely feel like work.  Most importantly, that trust allows us to focus exclusively on the activity of the fund and being supportive of our partner companies.  No time, energy or resources are wasted on questioning each others motivations, actions, decisions or feedback.

All of this has reminded me how much trust is fundamental to the success of startups (Homebrew is our own startup after all).  I would argue that no characteristic impacts the productivity, motivation, camaraderie and longevity of a team more than trust.  But how do you assemble a team that trusts each other when trust is usually forged through shared experiences over time?  Culture, values, transparency and many other things certainly contribute to building trust.  But the foundation of trust in every startup I’ve ever seen have it is a shared goal.

Whether you call it the Why, a mission statement, a shared vision, a true north or a common understanding of why the company exists, there is no replacement for everyone on the team knowing why they collectively and individually come to work each day.  Startups are faced with many obstacles, unknowns and failures.  People have to wear many hats and pitch in across many different areas.  There’s often little, if any, time to coordinate activity, assign responsibility or formulate a plan of attack.  When your team has a shared goal it becomes infinitely easier to assume, and eventually know, that your teammates are doing the right thing.

In startups, it’s the job of the founder(s) to repeatedly communicate the shared goal of the company and to make sure that anyone joining the team understands and shares that goal as well.  At Homebrew, we prefer to work with mission-driven founders because they seem to do this innately.  As a result, they are often successful in building teams and cultures that are based on trust.  And these teams leverage that trust to become high-performing, making work feel nothing like work at all.

Avoiding failure in early stage hiring

Nearly a year into Homebrew, we’ve learned a great deal about startups, investing and ourselves.  And we’ve also reinforced many of the things we believed to be true about each of those things.  Probably least surprising (and most painful!) to us and the companies we meet is how challenging it is to hire in today’s ultra-competitive talent market.  While the immediate goal of startups is to get to product/market fit, the right team needs to be hired before that can happen.  And when demand outstrips supply of talent, it’s easy to take shortcuts and to make hiring mistakes, especially when it feels like people are the main constraint to moving forward with your business.  As a result, we spend an incredible amount of time with Homebrew family companies focused on helping with hiring, including trying to help avoid common hiring mistakes.  Unfortunately, it’s an absolute certainty that hiring mistakes will be made, but you can improve your chances of success by being mindful of a few simple things.

Here are what we believe to be the most common mistakes (in no particular order and not a comprehensive list) that founders and startup teams at the seed stage make in hiring their earliest employees. Please share your thoughts on these and other hiring mistakes that founders should be sure to avoid.  If you have hiring tips or tricks, we’d love to hear about those as well because hiring is an area in which everyone can always be learning and improving.

Choosing aptitude over attitude: It’s easy to believe that a highly skilled candidate who doesn’t fit the culture of your company or who can’t play well with others will still help you quickly tackle the problems you face.  But history shows that undervaluing attitude and overvaluing skill actually leads to more problems, less output and lower team morale.  Make sure your hiring process includes a thorough screen for culture fit and for an attitude that reflects the characteristics that you believe to be the foundation upon which you want to build your team, product and business.  The right attitude alone isn’t always sufficient, but it’s always necessary.  Aptitude alone is never sufficient.

Hiring specialists over “generalists”: Early in a company’s life, the reality is that nothing is certain, including which aspects of the product will be successful and which skills are needed on the team to scale beyond present day.  Accordingly, startups can’t afford to have team members that are only able to do one thing well and not stretch beyond that one thing.  I suggest that startups hire “T-shaped” generalists who have a superpower but also have the flexibility in thinking, curiosity and desire to take on more than only what they know incredibly well.  Early team members are ideally multi-tool athletes with a particular strength who can also fill positions of need whenever and wherever they are found.  Hiring people who only do one thing really well can limit your potential paths to success as well as make it more difficult for those team members to be successful themselves during the early phases of the business.

Being seduced by credentials: “But she worked at Google and Facebook! She was a Director so she’s obviously a total rockstar. We need to do everything we can to hire her!” It’s easy to be allured by high profile names and senior titles.  But at a startup you need people who can get shit done and who don’t wait for others to tell them what to do.  Having done it before can be tremendously valuable, but only if he or she has really done it before.  Don’t rely on recognizable company brands and lofty titles when hiring.  And be wary of candidates who seem to be escaping from a large company rather than running to a startup.  Ask the questions and do the work to find out what the candidate really delivered at his prior job, how he went about doing it and whether he has the potential to continue to grow.  Experience at the right company or in the right role can matter, but there is no substitute for making things happen and having the potential to excel in the future.

Rushing to fill a need: Every company has a position that has been open too long or that seems critical path to success.  So it seems justifiable to hire the candidate who is “good enough” or who can “do what we need right now”.  But once you capitulate on a hire that doesn’t quite meet the bar, it becomes easier to repeat that behavior.  Introducing a mediocre hire into a high-functioning team inevitably creates friction, reduces trust and slows down progress.  Waiting to make the right hire is always less expensive (in time, energy and money) than fixing the damage done by hiring someone just because there is a gap that needs to be filled right away.

Being stingy with equity: I believe that being generous with equity for early hires is critical for building a culture where every team member has a founder mindset, feels responsible to the company first and is fairly rewarded for taking early risk.  A proper vesting schedule ensures that these early hires only earn their equity if they are contributing significantly to the success of the company over the long term.  In addition, issuing larger amounts of equity is a far better way of compensating hires given startups are typically cash-constrained and need to focus on giving themselves as much time (i.e. cash runway) as possible to establish product/market fit.

Ignoring hiring mistakes: This one happens after the hire is already made but it remains true that most founders fire too slowly.  Founders find it really difficult to trust their gut instincts around an employee’s fit for the company because they originally did so much work to make sure that the hire was the right one.  Founders also tend to look at it as a personal failure if a hire doesn’t work out.  But it’s important to accept that absolutely no one bats a thousand when it comes to hiring.  If an employee has lost your trust, finds it difficult to work with others or proves unable to deliver results, make the decision to move on immediately.  In my experience, founders always fire six months too late, even though they sensed the right answer earlier.  Trust your intuition around your team and make the hard call because it will save you and your team many months of pain and expense.

Other mistakes that are worth mentioning include 1) introducing too much diversity of thinking too early 2) overselling and not being honest about the company and role during the hiring process and 3) giving senior titles (VP and C-level primarily) too early.  There are many hiring landmines, but most of them can be avoided with some careful thought and a well-defined hiring process.  Investing early in hiring right pays off in multiples down the road, and beyond making sure there is money in the bank, is the primary responsibility of founders.  In a market where talent is scarce and the best talent has lots of options, it’s difficult but critical to maintain a rigorous process and to not compromise on the qualities of the team that are important to you and your culture.

Know what you’ve learned, not what you’ve done

At Homebrew, Hunter and I are very focused on “Why” a founder has chosen to start a company and what motivates him or her to attack the specific problem or opportunity he or she sees.  But also important is the “how”, the approach the entrepreneur has taken to address the opportunity.  Often, when we starting talking about the “how”, we hear about a lot of different ideas being considered and experiments being run in an effort to find product/market fit.  But at the seed stage, entrepreneurs often focus only on what they’re doing without being equally attentive to what they’re learning.  “Being busy” by itself does not equate to building a company. You should be learning with every step so that you can find a scalable model of success.

Focusing on the key questions and how best to answer them

To create an organization that learns and doesn’t just do, I’m a big advocate of the scientific method approach to building product (and companies more generally).  The scientific method is a simple framework that can help startups focus, experiment, learn and iterate quickly and effectively. Below is a description of that method along with a simplified example of an experiment we ran at Twitter (not the actual data).

Purpose/Question – As obvious as it sounds, you need to start with the question you want to answer.  Surprisingly, lots of startups take the “see if the spaghetti sticks” approach, just putting something out in the world and then somehow gauging the response.  Without clarity around what question you want answered, it’s difficult to design the right experiment and to draw the right conclusions from the data you collect.  In particular, it’s critical to know what metrics are relevant to the question you’re trying to answer.

Example: How can we increase the sign up rate of users visiting the Twitter homepage?

Twitter homepage in April 2011:

Research – If you have a question, it makes sense to consider all of the potential answers, even if many of them are dismissed quickly.  Research, whether that’s talking to potential users, evaluating similar products, conducting simple surveys or brainstorming as a team, does a few things.  Research helps uncover unspoken assumptions about the answer, identify unexpected potential answers and inform the design of the right experiment.

Example: Ideas that emerged from user research, looking at site analytics and from team ideation included better descriptions of what Twitter is, a video that explains how to use Twitter, showing popular tweets, simplifying the homepage by removing trending topics, simplifying the homepage by removing the search box, etc.

Hypothesis – What do you believe to be true?  That is the essence of your hypothesis.  And proving or disproving that statement is the goal around which your experiment should be designed.  Any test run without a hypothesis is unlikely to lead to learnings that impact product direction in the correct way because the experiment likely doesn’t have a control for what you believe to be true.

Example: Simplifying the homepage to focus on sign up by removing the search box will increase the sign up rate.

Experiment – This is what most startups focus on but only in the sense that experimentation means putting something out in the world.  More important than the idea of experimenting is the design of the experiment.  Simply put, you need to know what question you’re trying to answer, which answer you believe to be correct and which variables you believe impact that answer.

Example: Show the homepage without the search box to a randomly selected, statistically significant sample of users and compare the sign up rate to users that see the existing homepage during the same period of time.

Analysis – The reality in most product experiments is that you can’t isolate or control all of the variables, so it’s important to not be a slave to the data.  Data from the experiment usually needs to be considered one input into product thinking and not the answer in and of itself.  Accordingly, it’s critical to be honest about what the data does and does not say in relation to the hypothesis and question at hand.

Example: The sign up rate increased by 12% without the search box. But by removing the search box did we lose sign ups from people who searched and then signed up from the search results page?

Conclusion – In organizations both small and large, nothing is more important than providing the proper context for product decisions.  So when you arrive at conclusions from your experiment, be sure to share them quickly, clearly and repeatedly.  Was the hypothesis proven or disproven?  Did the outcome result in more questions and experiments or answers that you feel comfortable moving forward with? Communicate what you intend to do in reaction to the conclusions and start the scientific method process all over again.

Example: At Twitter, results from experiments and planned next steps were summarized and emailed to an internal mailing list for anyone in the company to review.  When changes went into production, another email was sent outlining the changes.  

The homepage that resulted from this experiment and several others was launched in December 2011.

Here is the current homepage:

Next time you’re working on experimenting and iterating to get to product market fit, remember the scientific method.  If you remember to have a hypothesis and to design an experiment that tests that hypothesis cleanly, you’ll be learning and not just experimenting.