It’s possible to raise VC funding even if you haven’t built a real product, according to Charles Hudson, founder and managing partner at seed-stage firm Precursor Ventures. It’s just very, very difficult.
I interviewed Hudson during TechCrunch Early Stage, our virtual event for startup founders. He gave a short talk titled “How to sell an idea when you don’t have a product,” then answered questions from me and from attendees watching at home.
Hudson said Precursor invests in about 25 startups every year and that a majority are pre-launch and pre-traction. So when he’s considering startups where there “isn’t any evidence or traction,” he and other investors are basically considering two things: How well the founder knows the industry, and how well the investors know the founder.
Of course, if you’ve already had success and you know everyone on Sand Hill Road, it might not be that hard to get that first check. But what about everyone else?
Below, I’ve quoted some highlights from Hudson’s thoughts about how to raise money pre-product. You can also watch the full presentation/conversation at the end of this post.
‘You need to have a unique and durable insight that will still be true in 12 to 18 months’
You need to have a unique and durable insight that will still be true in 12 to 18 months … The unique part is important because you still haven’t launched your product yet. And so whatever it is that you’re doing, if it’s not unique, if it’s a really obvious insight, you’ll probably have 10 or 12 competitors that are launched in the market by the time you get your product out.
If everybody has the same insight, everyone’s going be competing for the same customer, with the similar value proposition, using the same marketing channels. There’s a good chance that you’ll have what we call the “freeway off-ramp problem,” which is if everybody’s trying to get off the freeway at the same exit, you end up with a traffic jam. I don’t think that’s a good place to be for early-stage startups.
And the insight has to be durable, because you’re probably six to 12 months away from having your product on the market. So if the insight you have is: Instagram doesn’t have a button that does A, B and C thing, or Microsoft Teams doesn’t support this one function, the truth is, you don’t have that capability, either. The market’s not going to stand still while you build your product.
Classify your insight
Startups can be broadly classified into three core buckets. One is a business model insight, which is: Are you doing something new or novel on the business model that creates new opportunities for you? Oftentimes in consumer, that can be taking a model that’s dominated by ad-supported and doing a subscription play. In business-to-business SaaS, oftentimes it can be taking a product that other people charge for and making it free and monetizing through some other channel.
There’s a product insight, which is probably the one that I see most commonly presented by founders, which is, you have some product secret, or there’s some innovative technique or capability that you want to bring to market, that you think is going to completely change the way the world works.
And last but not least is this market timing insight, which is that there’s something happening in the market that you’re targeting, that creates new opportunity. That can be the move to the cloud, digital transformation — in the last year or so, I’d say GDPR and some of these movements around data privacy have created markets for products that maybe didn’t exist or didn’t make sense before.
I think it’s important to understand when you’re making your pitch to investors: What’s the nature of your insight? And I just want to tell everyone … it’s very hard to raise pre-product if your pitch is centered on a product insight, because the thing you’re telling me is that the most important thing I need to understand is a product that doesn’t yet exist. You can [still] do this, but I just think it’s important to reflect on what a tall order it is to sell an investor on a pre-product company where the product is really the innovation.
Understand your market
I think the other thing that founders need to think about is: What kind of market are you in?
Is the market crowded (which to me is a market with lots of competition, little or no differentiation)? I would say scooters and food delivery are categories that are crowded, the services are pretty similar … at least in the eyes of the consumer. Or in a market that’s fragmented (which is one that has lots of competitors of similar size with a little bit of differentiation)? Or even a segmented market, a market which I think of as a market of markets, where there’s a product for the high-end, a product for the mid-market and maybe a product for the low-end? Is it a concentrated market like search, where one player — Google — has a really large dominant marketshare? Or is it a nascent market that doesn’t have much in the way structure?
I actually think market structure really matters if you’re going to do a pre-product company, because this is going to impact your own strategy around launch and scaling. One thing I’ve learned the hard way as a venture capitalist is: It’s very hard to raise pre-product in crowded and fragmented markets.
Really, if you think about it, just going back, a crowded market is one that already has a lot of competitors, with little to no differentiation. So it’s hard to tell a story about how your startup and its launch is going to change that element of the market.
Fragmented markets that have lots of competitors of similar size with limited differentiation — oftentimes, all that tells me as an investor is that there is no big market, there is no big “aha,” there’s just a bunch of little small companies fighting over each other. In both cases, it’s hard to see how injecting another company into that market is going to fundamentally change things.
Tell your story
So how do you tell a good story that works? First and foremost, going back to the beginning, we talked about your familiarity with the market. If you have relevant experience, I would totally center the story in your pitch on what you know from your past experience. It really does work. It puts you in a really different category of entrepreneur.
Not every company that we fund at Precursor pre-launch, pre-product is an entrepreneur who has relevant experience and that background, but when you do, it really does help make the case for you and your company.
I would say, again, a lot of this is: Investors have mental models for what works. To the extent that you can tie your story to one of these mental models that investors have that already works, it makes the conversation a lot easier.
The four [mental models] that I tend to lean on most as an investor are segment focus — so if you’ve got a product and you just say, “Hey, you know what we’ve learned, we’ve learned that mid-market accountants are not well-served by the accounting software that that they’re forced to use. We’re going to build a product that better meets their needs.”
There’s the classic better, cheaper, faster, which is, “Hey, there aren’t good, cost-effective solutions for people out there, so we’re going to build something that works better.”
There’s market expansion, which is what Uber and Lyft did to the taxi market.
Then there’s greenfield, which I think is always a great place to be if you’re going to launch and pitch a new product — a brand new category that doesn’t have an established leadership or structure yet.
Some examples from Precursor’s portfolio
We were pre-seed investors in The Athletic, the subscription sports media service. When I met the founders, [Alex Mather and Adam Hansmann] were not media people. They had been working at Strava and they had a bunch of insights on free-to-premium subscription, and their pitch had elements of all the things I just described.
They talked about, “Hey, we have a business model innovation, we think that a subscription, consumer sports site will really work. We think there’s a big market of sports fans whose needs are underserved, so we’re going to actually expand what’s already a big market in sports journalism. We think that this business model innovation is going to give us a different relationship with our readers, because they’re going to be paying us 50 or 60 bucks a year, so we can do more in-depth reporting, we can cover teams and sports to a level of degree that maybe you can’t if you’re relying purely on advertising.”
The last thing they brought to bear was they said, “You know, we worked at Strava, and Strava has done a really good job of converting what was then a largely free user audience into a really great subscription business.” So they felt like a lot of the things that they learned about making Strava successful would apply to The Athletic, and it’s largely been true.
I’ve got one other one, where we were pre-seed investors in a company called Noyo … They built a Twilio-like API for the health insurance market. The two founders had worked together at Zenefits, and they had worked specifically on this : How do you help move data between insurance companies, insurers and employers? A lot of that work was being done in spreadsheets. And they’re like, “Hey, our job is to help our customers move these spreadsheets around. These spreadsheets aren’t necessary, we can replace these with an API.”
I liked the fact that they had real-world experience dealing with health care data. The pitch I feel that always works here is, “I’m building a product to productize a job I had at my last company.” That’s the story that I think investors always understand.
Don’t just chase the latest trends
At the beginning of shelter-in-place and COVID-19, almost every pitch I saw is like, “The new remote world that we’re all venturing into, we’re never going to leave our homes again.” And I just said, “Well, everybody has this thesis, which is that we’re all going remote and we’re all going distributed.”
Almost every pitch I saw that hit on those themes, I basically passed on them, because I felt like so many people were leaning into it. How’s the customer going to sort through 17 or 18 really similar-sounding pitches that are all trying to help you manage your newly remote team?
If anything, we tried to avoid the temptation to lean into telemedicine or remote work. Ironically, the best time to have started one of those companies is not today, it was 18 months ago, and to be a little ahead of the curve, because then you’ve at least got best practices and you’ve learned things along the way. So part of what we try to do is not get too caught up in today’s world, but [instead] actually find people who have a point of view about where the world is heading.
How to send a cold email
I try to read every well-written cold email that we get. Honestly, there’s only a couple of things I’m looking for. One is: Are you in our stage? I actually get three or four emails a day from investment bankers pitching me on $50 million expansion rounds. We do a million dollar rounds and less, that’s our bread and butter.
The audience might be surprised the number of times I get pitches where I have no idea what the company actually does. Even after reading the paragraph: “We’re an AI, ML, next-generation remote work collaboration solution.” I don’t know what that means, it’s like a word salad. So make it really clear what it is that you do, how much you’re raising and if you have a pitch deck, you might as well send it along. Because the other thing I’m trying to figure out is: Do we have any companies in the portfolio that are competitive? Because if we do, we’re going to pass just on the basis of that.
When to follow-up with a VC who said no
Oftentimes in my venture career, I’ve tried to get better at writing pass emails to people that make it really clear why we’re passing. A lot of times I just tell people, “It comes down to: You think that distribution is going to be easy, and I think distribution is going to be hard.”
So particularly for consumer companies, once you’ve gotten some evidence you’re able to acquire customers in a cost-effective manner, coming back and saying, “Hey, last time we chatted, you had real reservations about distribution. We’ve acquired our first thousand customers, 500 of them were organic and the other 500 we acquired with paid acquisition, we got them for 25 cents each, so we think we’ve been able to crack the code.”
I’ve just found that for me, writing good, honest pass emails also helps me remember when the time comes up, when the founder comes back to me, what was in that moment that caused me to say no.
Common mistakes in the pitch meeting
I’d say the two big ones are [first,] market size. Because we’re usually dealing with pre-launch, pre-product companies, I’m very focused on bottoms-up market segments. You telling me that cloud software is an $82 billion-a-year business and — well, yes, that’s a fact, it doesn’t at all help me understand how you’re gonna build your business from zero to something meaningful.
So I’m much more interested in someone saying — excuse my accounting examples — there’s 35,000 accountants that work in mid-sized companies with $1 million to $25 million in revenue and they spend eight hours a month closing the books. Those are the kind of things that show me that you have insight about your product.
I think the other thing is, a lot of times I ask people, “What’s the most important thing I have to believe to be true about your business, in order for me to invest.” In most startups, it comes down to one or two things. The number of times people are just — they give me four. I want the one, the most important thing. If you’re a marketplace, it’s usually accumulating supply or fueling demand with a consumer product. Sometimes it’s like: Hey, can we get enough early people interested in, excited about this product to actually make it grow?
Because I like to know that I’m aligned with founders around the most important question they’re going to try to solve with the money that we give them.
The VC industry’s focus on who you know is bad for diversity
I think this is the biggest blind spot we have in venture, and so we work really hard at our fund to change that. We’ve backed over 200 companies, the vast majority of them were started by people I did not know very well at all before I met them, and I’ve gotten to know them by being investors in their company.
My summer interns are doing a study. I think when I look at the data, only about 10% of our portfolio company founders, less than 10%, went to Stanford. And we’re a Bay Area-based firm. I’m guessing that’s lower than most venture firms. It’s not, obviously, representative of the population as a whole, but low by venture standards.
We have a dashboard at our firm where we track for every company that we invest in a bunch of statistics about the founding team — racial, gender, age, a bunch of things. And I’m pretty pleased.
But I’ve been doing this for a long time, and I would say until five years ago, most people said, “It’s irresponsible and dangerous as a venture capitalist to invest outside of your network. You shouldn’t do that. The point of the business is to give money to people where you have trust and shared experience, which means you’re going to end up investing in people you’ve worked with before who went to your alma mater, who lived near you.” If you’re given any amount of money in San Francisco, that’s going to exclude a lot of women and people of color, because the Bay Area is not a terribly racially diverse place when it comes to the business community.
We’ve tried really hard at Precursor to make sure that we actively combat [only] investing in people from our network. But if you’re not careful, as a venture capitalist, it’s very easy to just fall into a rhythm of recruiting people that work at your firm who went to two schools — [Harvard Business School] and Stanford — and who worked at three or four companies. We try really hard to be an example and do things differently.
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