Homebrew Year 3: The Path to Investment

We had an incredible day last Thursday as we got together with our LPs, founders and advisors for our 3rd Annual Meeting to review Homebrew’s progress over the past year.  Hunter already wrote about what we said we know and don’t know after three years of Homebrew.  One of the things we talked about was being eager partners to other investors and also hungry competitors.  But the opportunity to partner or compete is predicated on the lifeblood of any fund: deal flow.

Picking great startups and winning the opportunity to invest in those companies is clearly critical to the success of any VC fund.  But it all starts with seeing the best opportunities in the first place.  Potential investment opportunities can come from known connections like operators, investors, or service providers.  But they also come in cold based on reputation and are generated actively via outbound outreach.  And we do our best to provide an answer (almost always a “no”) to every single company.  After year one, I wrote about our deal funnel.  It’s time to revisit the data after a couple of years of refinement.

Here’s how our overall investment opportunity funnel broke down in 2015:

  • ~1600 opportunities evaluated (100%)
  • 476 companies with first meetings or calls with either me or Hunter (30%)
  • 64 companies that then had a meeting with both or the other one of us (4%)
  • 14 investment offers made (0.9%)
  • 10 investments made (0.6%)

Of the ~1600 opportunities we saw, here is how those opportunities were sourced:

  • 35% from entrepreneurs and executives in our network
  • 27% from other investors (includes angels, VCs, accelerators, etc.)
  • 3% from service providers (legal, finance, etc.)
  • 35% from other sources (inbound, proactive outreach or ideation)

Coopetition and our seat at the table

It might be surprising to some to see that over a quarter of our opportunities come from other investors (up from 16% in our first year) but the VC ecosystem at the seed stage is very cooperative.  Seed rounds seem to range from $1.5m-$2.5m nowadays and most seed firms don’t write checks that large (larger funds are a different story).  As a result, nearly every financing round has a syndicate structure with several VCs and angels participating.  Our approach is to be the investor of record in the round.  To us that means being the lead or co-lead investor (writing one of the larger checks, from $500k to ~$1m) for only 8-10 companies each year, typically taking a board seat and then working closely with the founders to help them build the company that they envision.  

We’re very transparent about this approach with both companies and other investors.  And we work hard to make sure that they see a clear seat at the table for us based on our approach, experience and potential contributions to the company.  Often times we’re able to work with other VCs in supporting a company.  Sometimes it means that we beat out other VCs for the opportunity to invest and sometimes it means that we get beat (4 times in 2015, of which two were originally seed rounds that became Straight to A’s).  But it’s super important to us that irrespective of the outcome with any particular investment opportunity, we treat other VCs with respect and honor their potential contributions to a company.  It’s one reason that we’ve had the good fortune of seeing so many wonderful opportunities from our fellow VCs.

Hustling to find the best opportunities in areas we care about

The percentage of deals that come from other sources has also increased (up 10% from year one), driven largely by our outbound efforts.  While not exclusively thesis-driven, we do spend a lot of time thinking about markets or trends we liked to invest in.  We then take those interest areas and try to identify and contact companies or entrepreneurs doing innovative work in line with our theses.  Not coincidentally, 3 of the investments we made in 2015 were the result of outbound efforts.

Open to inbound

We get a lot of cold inbound emails from founders asking us to invest.  The form emails that are clearly being sent to a large number of investors get rejected quickly.  But on occasion, a truly thoughtful, personalized email appears in our inboxes and grabs our attention.  The sender has clearly done his or her homework on our investment approach and areas of interest.  And the email contains data or a demo that tells a compelling story.

We respond to all cold inquiries because of emails like those and because we want to be at least somewhat helpful to founders who take the time to express interest in working with us.  We believe that there is an opportunity to grow the pie and impact founders beyond just our portfolio given the platform we have as VCs.  And every so often, this “extra” work yields a match.

Just as in Fund I, we have one investment in Fund II that is the direct result of an inbound email without a warm introduction.  You’re much more likely to have success getting any VCs attention if you’re referred to him or her, but if you’re going to send a cold email, make it clear why your company is a potential fit for the investor and back up that story with data or a demo.

Tightening our filter

Since we started Homebrew we’ve continued to refine our investment criteria and judgment to make quicker decisions so that we don’t waste founders’ time and so we can allocate as much time as possible to our existing portfolio companies.  Our goal is to take a deliberate path to conviction rather than circle an opportunity to see how things play.  Our diligence focuses on the questions that we think are appropriate for a seed stage company that hasn’t yet obtained product-market fit, not endless data requests and busy work for founders.

We only take a first meeting or call when we see something about a team, product or market opportunity that signals it could be special.  While we reduced the percentage of companies with which we take a first meeting from 45% to 30% in the past two years, we’d like to continue to drive that number down, probably in the 20-25% range.  Every meeting can be educational or lead to an important relationship, but we err on the side of getting to “no” (and once in awhile “yes”) as quickly as possible.  And usually that means even before a first meeting.

Sticking with unanimous decisions

Every single investment we make is one that both Hunter and I are excited to put sweat and reputation behind.  There’s no such thing as Satya’s investments or Hunter’s investments.  There are only Homebrew investments.  It’s been this way since we started and only if we someday have 3+ partners do we expect that to change.  In the meantime, every company we invest in spends time with both us of during the diligence process.  If after a first meeting (and usually some preliminary diligence) one of us believes that the team, product and market collectively represent a strong candidate for investment, the other partner is brought in to dig on the 2-3 key outstanding questions.

At the end, we believe we need to be early or contrarian (and eventually right!) when making investments.  There has to be something unique about the combination of the team, the product and the problem being addressed that compels us to write a check.  We tend to be less interested when there is a market where a dozen companies are doing effectively the same thing.  Unless we see a very clearly differentiated approach that has long lasting differentiation, we’re likely to pass.  

That’s not to say those companies won’t be successful or won’t be able to raise seed money (in most cases they do).  They’re just not the right opportunities for Homebrew.  Many times we feel very confident that those companies will likely be successful in raising capital beyond the seed round.  But we’re very comfortable foregoing short term write-ups to avoid what we perceive to be long-term pain.  The net is that we’d like to get more efficient in this process as well, decreasing the percentage of companies that meet with both us from 13% of companies that have a first meeting with us to 10%.

For the curious, our average core investment in 2015 was $799k.  We invested in four Bay Area companies, 4 NYC companies and 2 LA companies.  Three of the companies had female members on the co-founding team (including two female CEOs) but none had founders from underrepresented populations.  We’re working diligently to try and address the last issue because we know that to be a top-performing fund we need to back a diverse set of founders.  We also emphasize with our companies that diversity within the first 20 hires will make for better startups.  Finally, we’re doing our best to stay on top of our own unconscious biases.  It’s early, but we hope to make real progress here in the coming year.

So what?

Based on the opportunities that we see, we have great confidence that a very successful fund can be built by investing in the right subset of those companies.  Ultimately, we won’t know for many more years whether our picking will yield an incredible fund.  But we do already know that we’ve invested in incredible people.  People who we are so proud and excited to be working with.  It’s these people and the ones we’ll back in the future that lead us to work every morning.  We’re so lucky they’ve chosen to partner with us.  We try to remember that every day, but it’s never more apparent than on the day of our Annual Meeting.  As Hunter and I said after the meeting “How. F’in. Lucky. Are. We? Very lucky.”  Hoping we’ll continue to be as lucky until our next Annual Meeting!

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What’s your startup’s superpower?

The sky is falling in the venture financing market!  Warnings, exhortations and admonitions are being written and spoken everywhere.  A market in which capital was abundant is now increasingly constrained.  So what’s a startup to do?  The reality is that you probably shouldn’t change anything about your business if you’ve been running it rationally.  Capital is really only a tool at the early stages.  Capital enables you to exist, it doesn’t enable you to win.  More important than ever is being able to answer one question.  What are you going to be the best in the world at doing?  Answering that question will help your company focus on unlocking its superpower, the skill or asset that truly sets it apart in the market.  And that will allow you to survive, and even thrive, in any fundraising environment.  

As a VC, I see a large number of startups, often times multiple startups pursuing the same opportunity at the same time.  In all of these situations, Hunter and I care a ton about the “Why”.  But just as important is the “What”.  And the “What” has to be a vision that contemplates what will truly differentiate the startup in the long term.  Too many companies we see think that being first to market, raising the most capital and spending it quickly will lead to winning.  That’s never been accurate, and it’s both wrong and dangerous in today’s market.

Google is best in the world at search.  Facebook is best in the world at building a social network.  Apple is best in the world at building integrated software and hardware for consumers.  All of those markets are or were incredibly crowded.  But knowing what they wanted to be best in the world at helped them figure out what superpower they needed to develop.  Google knew that to be best in search in needed the best data infrastructure.  Facebook knew that if it wanted the largest social network it needed a competency around growth of that network.  And Apple knew that if it wanted to build devices for the average consumer, it needed simple and beautiful design.  Arguably, these superpowers didn’t just help those companies win.  These superpowers helped them maintain their market leadership as well.

Whether you’re bootstrapping or flush with VC money, it’s worth asking what your startup’s superpower is going to be.  Once you answer that question, you can focus on the development of that superpower rather than on things that make you temporarily different or different in a way that is easy to replicate.  Success at building your superpower will lead capital to seek you out, even in a market where it’s trying to hide.

The two goals of startup fundraising

Money’s been flowing. VCs have been investing money at levels not seen since the bubble year of 2000. Entrepreneurs have been raising enormous amounts of money at valuations that assume years of future growth and eventual profitability. So what’s the downside of all this? That entrepreneurs mistake what they’re reading on Techcrunch as the reality for their own companies both now and for the foreseeable future. Raising money seems like a cakewalk, but that’s only because you don’t read about the failed financings, down rounds and recaps nearly as much as the unicorns and decacorns. And warning signs are emerging that the cascade of cash is about to end. The reality may be very different soon, and that’s something that we’ve emphasized to our Homebrew partner companies as they’ve hit the fundraising trail this year. Fundraising is confusing, frustrating and all-consuming at its worst and informative, exciting and rewarding at its best. But regardless of the process, we like to say that for all startups there are only two goals in the fundraising process: put money in the bank and maintain optionality.

Put money in the bank: The number one goal of fundraising is to get money in the bank so that you have the opportunity to solve the problem you set out to solve. If you’re fortunate enough to have a story or metrics that attract multiple term sheets, feel free to aggressively negotiate pricing, structure, syndicate partners, etc. But more likely is that you won’t have so many options and you’ll need to accept the terms you’re offered (more or less) so that you can live to fight another day. The number one cause of company failure is running out of money. And many times the key to winning is just surviving so that market timing finally lines up with your product or service. If you want to build a high-growth, venture-backed startup, do whatever it takes to push cash on the balance sheet. That way, you’ll be able to fund operations to hit the next set of milestones that will allow you to raise additional capital or achieve profitability.

Maintain optionality: It’s incredibly tempting to raise as much money as you can at as high a valuation as you can. All startups believe that with more money they will accomplish more in the same amount of time. But in our experience, constraint is what yields innovation and results. More money typically yields more spending. Companies often end up trying to solve problems by hiring more people and burning more cash. In the meantime, the bar for the next financing has been set much higher because investors expect to see greater results given the larger amount of money and the higher price at which it was raised. Everytime you raise money, consider that you’re cutting off possible paths in your financing/exit decision tree with every increase in dollars raised and valuation. While every founder envisions building a unicorn, the odds are that if your company is successful, that success will be at an exit value much lower than $1 billion. So why not approach your financing in a way that maximizes your options for raising more money when you have additional data that gives you the confidence to take more risk and double down on the business? Or why not maintain the option of accepting an acquisition offer or going public at a fair valuation and still generating incredible wealth for you, your employees and your investors? With a currently mixed exit environment (even for unicorns) and historical exit data skewing much lower than $200 million, maintaining optionality through your financing can be the difference between surviving or winning and the failed financings, down rounds and recaps that no one wants to talk about.

Raising large amounts of money has been glorified. Being able to do it quickly and painlessly has become the expectation. But the reality is very different and likely to become more so as the market adjusts to a reality with few exits and difficult to justify valuations. So just remember that at the end of the day, only two things matter when it comes to fundraising. Put money in the bank and maintain optionality. Give yourself the ability to control your startup’s destiny and take on more risk only when you feel ready.

Startups are hard. Don’t go it alone.

I suppose I shouldn’t be surprised that with the continuous growth in the number of startups (we’re seeing between 150 and 200 new seed opportunities per month at Homebrew), we’re also seeing a related trend in the growing number of companies being started by solo founders.  I’ve taken a particular interest in this because Hunter and I have a strong bias against investing in solo founders (although we have done it once so far).  This clear shift in the market caused me to reflect on why we prefer founding teams over founding individuals.  In fact, we prefer teams that have known each for a long time and ideally have worked together before.  While solo founders can absolutely build great companies, I think we’re right that having a founding team materially increases the chances for success.  Building a great company is hard enough.  It’s even harder to do it alone.  In no particular order, here’s why having co-founders can be helpful:

Idea validation: If you can’t convince someone else to join you in pursuing your idea, maybe it’s not worth pursuing.

Pressure to perform: Having a co-founder makes you responsible to someone else, which in turn puts pressure on you to deliver results, probably faster than you might otherwise.

Emotional outlet: In startups the highs can be high but the lows can be low.  And the inevitable trough of sorrow can be a lonely place.  Surviving the anxiety and emotion of a startup can be much easier when the burden is shared.  It’s great to see much more dialogue about the emotional challenges of being a founder.  One way of fighting depression and other forms of emotional distress is by having a co-founder with whom you can be open and honest about your fears, struggles and insecurities.

Skill diversity: No one person, no matter how brilliant, has all of the skills needed to make a startup successful. Having co-founders with complementary skills can make it much easier for each person to say no to everything but the tasks most critical to achieving success.

Hiring strength: Multiple people on the team means a broader network from which to recruit, a diversity of skills with which to evaluate candidates and a more pronounced culture for potential hires to experience.  Having co-founders just makes hiring easier.

Sounding board: Co-founders lie awake at night worrying about the same things as you. They’re just as committed to the mission as you. And they’re equally invested in seeing all parts of the company work as you.  And so they will challenge you, scold you and push you (and often hug you) unlike anyone else at the company can or will.

It’s important to note that having a co-founder just for the sake of having one, or randomly meeting one at a “dating” event, isn’t the answer.  Having the wrong co-founder can be more damaging than going to alone.  There’s lots more to say about finding the right co-founder(s), but it starts with having shared vision, shared experience, trust and complementary skills.  It means having alignment on goals, culture and values.  It doesn’t necessarily require equal equity or compensation, but it does mean early agreement on those things.  Finding the right co-founders can be challenging, but we strongly believe that the startups most likely to become the best companies are founded by teams that belong together.

What We’re Curious About at Homebrew…

Every day we meet amazing founders sharing their ideas for how the future will evolve. In fact, we see about 150 new companies each month. Where do these teams originate from? Roughly 65% are referred to us by other founders or people we know. 25% are introductions via investors – either angels or VCs. The remaining 10% are a combination of cold inbound/outbound sourcing, often based upon a specific area we’re investigating. So recently we asked ourselves a question “is there strategic value in keeping our list of interests to ourselves?” That didn’t seem like a very good idea if our goal is to connect with thoughtful founders or inspire conversation. And thus http://bit.ly/HomebrewWhatIfs

What Ifs will be an dynamic list of ideas, questions and technologies that we are curious about and specifically want to connect with entrepreneurs to discuss and learn. We’ll edit, add and remove items as appropriate and link to our longer blog posts when it makes sense.

If you’re a founder in one of these areas or someone with domain expertise, we hope you’ll reach out. Do we hope to find new investments this way? Sure, but we’re also happy to just learn and hopefully help.

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.