Frontline Seed, Insights

How this VC thinks about pre-seed investments

Posted 01 August 2019
By Finn Murphy

When Frontline say we invest early, we mean it.

At Frontline, 70% of our investments have been pre-revenue and 60% pre-product. At Pre-Seed and Seed, there is little to be learned from intensive quantitative analysis pre-investment (woo). That said, over the past year and a half at Frontline, I’ve built a qualitative framework, designed around four key questions, to help me quickly assess the companies I meet. Together, I believe that these four questions are critical in predicting success.

Can you convince me to quit my job?

The first question I ask myself is; would I quit my job at the fund and work for these people on this problem? I know, it seems like a completely crazy idea, you (the founder), are here for the VC’s money, not to get them to join your team. Consider this though, when you pitch to a VC, you are looking to inspire and excite. At our stage of investment, it’s about taking a leap of faith and believing in your vision and your team’s potential. Surely, this is also what you do when pitching talent you are looking to hire. So, if you can convince a VC invest in you, great.

If you can get a VC to actually join your team, all the better.

Sarah Tavel was so excited after meeting the founder of Pinterest that she invested and swiftly left Bessemer to join the company. Pinterest is now a 15 billion dollar business. It wasn’t that way when Sarah joined — it was still another start up trying to break through the noise.

So, why is this is a good heuristic to access early stage companies? The key assumption we’re making in venture is that you’re going to build a big business and the essential ingredient in building a big company is the ability to hire the best. In the early days you’re unlikely to be competing on compensation, option grants are a long way from ever paying the bills, and the hours will likely be long and hard. The one thing that will attract top talent is your ability to tell a compelling story, display a truly unique insight into the problem you’re solving and to be overwhelmingly impressive when you first meet candidates. The team isn’t assessed just on who’s in the room, it’s imagining who might be in 12 months time.

From chihuahuas to exit, can you find a big enough market to scale?

At Frontline we track all the reasons why we pass on companies — market size, competitiveness, price, strength of team etc… We then review all the companies we’ve passed on and check in on how they’re doing using the metric of funds raised (not-ideal, we know, but it’s a simple public indicator of success).

Here is a picture of a Chihuahua
Here is a picture of a Chihuahua

Surprise, surprise. Our data has shown us that multiple cases where we liked the team but passed on the opportunity because we thought the market was too competitive, we were often wrong. The reality is that good teams can succeed in hot markets. In those cases where we also liked the founders, but passed because we felt the market was too small, we have found that founders go on to struggle.

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact” — W. Buffett

Warren Buffet lives by this mantra and the data proves it.

Even if you’re good — when you go after a small market in the early days you tend to go deeper into the niche rather than expanding outwards. This can cap your upside and in venture if we don’t think there’s a viable route to an investment returning half our fund, we are likely to pass on it. Here’s how that practically plays out, on the back on an envelope:

  • Frontline Ventures Fund II — $70M
  • Target Ownership at Exit — 10–20%
  • Required company value at exit — $150–300M
  • B2B SaaS forward revenue exit multiples — 5–10X (if growing minimum 2X YoY)
  • Company revenue required at exit $15M-60M
  • You can usually never expect to own more than 10% of any market so the smallest addressable market we consider for an investment is about $150M — in reality to find that market segment you need to look for $1B+ Markets (or be able to make the case that the market is growing or that you can create it)
  • This is fund by fund. Some funds don’t care about ownership/exit multiples — they just care if they think you can build a $10B company and can they get a slice of it.

Larger target markets give you flexibility in the early days to figure things out. Longer term, you must then narrow your focus as you get closer to your customer because once you go deep on a customer segment, it becomes much harder to get back to a larger market without pivoting the company.

One of the best (non-software) examples of this is chihuahuas. (Yes, you read it correctly). Imagine you’re starting a pet-food business and you decide to start with gourmet, home delivered meals for chihuahuas. Let’s say it’s a $50M market (🤪) that no one is addressing specifically, you can get a big slice of this right? Sure, there’s plenty of chihuahua owners. Plenty of them might have a high willingness to spend on their dogs’ health. But what if it turns out chihuahua owners aren’t as loose with their wallets as you thought? You’ve gone too deep too early and now all that adorable marketing collateral goes into trash can.

What you could have done is start with the pet food market (multi-billion dollar market). Move down into dog food market (still multi-billion dollar market). Then go gourmet. Still a huge market and very competitive. But if you follow the rule that you’re never going to own more than about 10% of a market in a best case scenario, it is always wise to target the larger opportunity. Chihuahuas might turn out to be the right answer — but so might the Maltese or perhaps Pugs.

Analogy inspired by the v cool Butternut Box.

The world is changing by the day. Yet, major shifts in platform and underlying technology only really happen once every couple of years. The shift to mobile in 2009/10 and the shift to cloud in 2012/13 spawned dozens of new unicorns. More recently in the UK, the opening up of financial regulation in 2014 has spawned some of the most successful breakout European companies in recent memory.

Often the way these changes empower start ups is by opening up new distribution channels. Founders are up against sophisticated sales teams with great brand awareness and multiple routes to reach their customers. But what these incumbents gain in scale they lose in awareness and speed. New routes to customers inevitably open up — and founders that can find these channels early are on their way to building great companies.

One of the best examples of this is the rise of self-serve in SaaS. Founders like Melanie Perkins of Canva that recognised the early trend rode the wave of lower acquisition costs and viral distribution when it was at its peak, and has now built a huge company. Older companies such as Hubspot had to transition from an inside sales-driven growth model to a freemium-product led strategy. For a company like Hubspot making that transition is expensive and hard. As a startup, you can do it tomorrow.

As a Founder, it’s important to recognize key changes in technology and/or customer behaviour that will allow you to create new value.

Missing pieces?

Was there a missing piece of functionality that previously did not exist, and that you can now leverage?

Old products become bloated by features whilst new paradigms make better, faster and cheaper products possible. This is a startup’s opportunity. Think about mobile-GPS enabling ride-sharing & food delivery, AJAX enabling fast content consumption in a browser, or accessible machine learning frameworks like TensorFlow opening opportunities for new analysis.

Who are your beachhead customers?

Finally, when meeting new founders, I am always looking for beachhead customers. If a product is to be adopted by new customers, a general rule of thumb — pulled from Zero to One — is that it has to be 10 times better than the existing alternative.

Of course on day one your product isn’t going to be 10X(lol) better for all your potential customers. It’s not even going to be close for a lot of them. But customer pain is a sliding scale. For most customers your initial product might only be a 2/3X improvement. But there will be a group for whom the pain you are solving is most acute.

Find these customers and obsess with solving their problem. When you do, nurture them. Grow a loyal and effective group of early advocates who love your solution. Leverage this group to raise capital and as you develop your offering you’ll find you’re a 10x solution for more and more of the market.

TL;DR

Early stage VCs don’t look too closely at the product or the technology as those are rarely the things that trip up early stage founders. It’s almost always one of the below.

  • The team isn’t right.
  • The market is too small.
  • The market isn’t ready.
  • The company is unable to find early customers.

If you’re speaking to us at Frontline know that this is the lens through which I evaluate each opportunity. I know it isn’t perfect, but I hope this gives you some guidance on how to shape your approach. And, If a VC turns you down don’t be too disheartened. I got turned down by Frontline when I was in the early days of fundraising.

There’s myriad reasons why you can be rejected: some subjective, others less so. At Frontline we try to give constructive feedback to all the companies we engage. It can be hard to tell a founder you don’t believe in them personally. However, more often than not, that’s the real reason. Figuring out why VCs make the decisions they do is another part of what it takes to build a big company.

And remember, the ‘picking’ part of venture is tough. It’s as much our job to get it wrong as it is to get it right (50%+ of pre-seed investments fail). But we want to partner with founders as early as possible — and as soon as you have a vision and a plan together. Ping me on finn@frontline.vc if you want to chat or just tell me why most of the above is wrong.

Special thanks to Lola, Tom, Max, Dec, Connor, Kezia & Will for tearing this apart numerous times in draft. Also special thanks to Carolina who is the coolest and smartest Frontline team member and did the final proof.

Originally published on the New Frontiers Blog

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