We published What We Invest In to give a sense of the general stage of a business, check size, geography, sectors, etc that we are interested as a fund. But we will still see hundreds and hundreds of companies that broadly fit those criteria, so how then do we filter down to the founders and companies we decide to invest in. Below are several core questions I ask myself when working on an investment decision.
Is the market a fit for our thesis? Will other founders + VCs pile in if the market is proven? Can they create a micro-monopoly?
The common wisdom in venture is to look for founders attacking big markets. “If everything goes right how big can this get?” is a common mental model. We take a distinctly opposite approach:
- We look for opportunities where the company can build a micro-monopoly, becoming the dominant go-to product in a market that is otherwise too small for BigCos or VC-backed founders to want to compete in.
- We actively avoid markets that are obviously hot or likely to attract tons of founders and investors piling in. Escape competition through niching.
Do the founders have an unfair advantage?
Building a great company without raising tons of outside capital and giving up most of your company is hard. Successful founders often have earned some kind of unfair advantage prior to starting this company. I usually look for an unfair advantage in either differentiation or distribution… or both.
Differentiation is about the ability to build a product that is significantly (investors will always say “10x”) better than the next best alternative, wether an existing product or some other manual or expensive process.
Distribution is about being incredibly effective at reaching and converting your target audience.
Note: This is often explains the dividing line between a “good business that you should stick to bootstrapping” and one we can back and get a good return.
Some examples of unfair advantages:
- Deep industry expertise: you will see a ton of portfolio companies at Earnest that follow a similar pattern: a founder works in a specific relatively niche industry, discovers the software they have availabile is terrible, either learns to code or finds a technical co-founder, and builds software for the industry they know extremely well.
- Super-Builder & Pace: sometimes you meet founders who are simply highly effective prolific product builders that can crank out high quality product improvements at an incredible pace. Even without industry specific knowledge, this unfair advantage can be a huge boost early on. Another variation of this would be a founder that is incredible at direct sales.
- Audience + Market Trust: I don’t believe an audience is a necessary pre-condition for a successful startup, but spending years in advance building up the trust of an audience that is either directly in your target market or adjacent to it is an excellent way to get cheap high quality distribution to help the business get to critical mass.
Is there market momentum? Is demand intense enough? Is it “secret”?
When thinking about the demand or the market for the product, I think in terms of intensity and momentum. Ideally, this demand is non-obvious some sort of secret discovered by the founder .
Intensity: Ideally the demand for the product is intense. This is related to the “is this a pain pill or a vitamin” question but I don’t think that’s as important of a distinction as getting a feel for just how intense the demand is. If it solves a really big pain or is a vitamin that gives you freaking superpowers, that’s better than either with only modest demand. A good indicator here is a really strong average revenue per customer (for SMB SaaS something like $200+/mo per customer) and very low or negative churn.
Momentum: manufacturing underlying demand is very hard and expensive (eg an old school Mad Men-style marketing campaign) so ideally we’re looking for demand that has a natural increasing pace to it where more and more potential customers are showing up each month. Momentum will most obviously show up in organic customer acquisition channels generated a good flow of trials each month. But more often than not we have to assess this qualitatively.
Secret: Markets that very publicly and obviously have momentum and intensity of demand often do not make great opportunities for bootstrappers and Earnest companies. When everybody can see it, they are likely to pile in and make differentiation and distribution much harder or more costly. The best markets have a kind of secret.
Some ways a good market can be secret:
- Be Early: sometimes just living on the cutting edge and getting to a market first before it hits mainstream is enough.
- Latent demand: it’s often best if the demand is not currently something your customer is explicitly spending money on, but is paying for it in other ways like with their time or frustration. This is harder to discover but more valuable when found.
- Niche industry: it’s a recurring theme here but just operating in an area of the economy that isn’t well known is a great way to find secret demand.
Is the business capital efficient? Can this be “first check, last check”?
A fundamental aspect of our thesis is the idea that for many businesses it now takes a lot less capital to get to key milestones in the business. We try to avoid obviously capital-intensive businesses like e-commerce with a heavy inventory component, but we also look for non-obvious ways that the business could become capital intensive over time including a need to hire talent in a skillset that is highly in demand.
Some evidence of capital efficiency could be:
- Full-stack in-house team: If the core team can build the product really well without pushing themselves to the limit, it’s incredibly valuable to have that slack in the business where you don’t absolutely need to hire more people to get to the next phase.
- Very low/negative churn: efficiency throughout the customer acquisition funnel means lower pressure to grow every month to stay afloat, more optionality to find the best/cheapest way to continue growth.
- Low break-even point for minimum viable team: this one is hard to describe but each business will likely have a “minimum viable team” where everyone is not burning the midnight oil, can take vacations, and isn’t constantly expected to do 3 different roles simultaneously. That point, and the amount of revenue needed to be at break-even, varies from business to business and a lower number is more capital efficient.
Is the business model in my circle of competence?
I often say that the Earnest thesis encompasses a huge mass of the economy in a way that is much broader than the kinds of businesses that Earnest, and more specifically “I” as only investing partner (for now), feel comfortable investing in. I try to stay within my circle of competence and understand when a business might otherwise be a good one, but not something I’m qualified make an investment decision on.
I generally describe this as: the center of gravity is B2B software as a service. A core piece of investing is backing founders and companies that push at the edges of your circle of competence. And learning quickly about the aspects of a business you don’t already understand is one of the most fun parts of the job. So I think the center of gravity concept makes sense where we may stray in B2B marketplaces, or technically B2C subscription apps that looks a lot like B2B, but we are never going to make a bet on a mobile gaming studio with in-app monetizing. Just not our circle of competence.
Are the founders values-aligned with Earnest?
Last but most importantly, I am looking for founders and businesses that are aligned with our values at Earnest. This is doubly important since we do a lot more than write a check; we bring founders into a community of mentors and other founders who help each other solve problems, stay motivated, and succeed together. There’s more to it but I would summarize it as low-ego founders building calm companies who will balance the sustainability of their company and team with growth in a healthy way.