To Get Funded, Have Vision And Understand Your Market
This piece is adapted from a conversation between FundersClub CEO, Alex Mittal, and Charles Hudson, founder of Precursor Ventures. We have edited for clarity and brevity. You can watch the entire live interview on Facebook.
As the startup world has advanced, so, too, have the size of the checks that budding companies can land when seeking early funding. Part of this effect is due to the success some investors have had in the space, which engenders more investors to seek it out, and some of it comes from bigger, professional VCs moving down from bigger rounds into seed rounds, trying to capture value.
Charles Hudson founded Bionic Panda, a gaming company that was acquired by Zinga. He later worked at Softech as a venture partner before starting Precursor Capital, a firm that is dedicated to investing in the preseed space, which Hudson defines as rounds that, typically, are smaller than $1.5 million, but larger than most friends and family rounds.
Working in the preseed space, Hudson meets hundreds of founders a year as part of his process to find that handful of investments that fit his fund’s investing ethos. As a founder himself—now again with Precursor—Hudson has invaluable insights in how founders should approach their companies, their markets and investors.
Here are some of the most trenchant takeaways from Hudson’s chat, with the full conversation below:
- Founders should have a nuanced understanding of their market’s structure, the ways in which it can be hacked, and the rules that are sacrosanct.
- Startup founders should have a firm understanding of who, exactly, their competitors are. That goes from other startups on up to big enterprise incumbents. Founders should know each competitor’s weakness—and its strengths.
- It’s important to have clarity of vision. “Have the next two to three steps in the journey mapped out,” says Hudson. No startup ever grows exactly to plan, directly on a predetermined path. But founders still need plans. They need to show they’re thinking clearly about the future of their company a year, two years, three years down the road.
- Entrepreneurs in emerging spaces, such as drones, should have visions that go out even farther, 7 to 10 years. These founders need to inspire others, including investors, at a grand scale to be successful. Without long-term vision, they can’t do that.
- Brand is just as important for investors as it is for entrepreneurs and startups. An experienced and successful entrepreneur will have an easier time raising money. And a successful VC firm will have an easier time landing good investments. New VCs have to work harder, just like first-time entrepreneurs.
- The No. 1 red flag that Hudson observes among startups: cofounders with clashing egos. It can be quite apparent from the get-go, even in that first meeting, when founders are talking over each other in front of a prospective investor.
- Founders should have a firm handle on their businesses margins and its projected margins. Hudson is constantly surprised by how many entrepreneurs have scarcely considered these things.
The full, edited conversation:
So we hear people talk about pre-seed and classic seed. What does that mean? Could you define what pre-seed means to you?
Yeah, I think the venture industry is still trying to sort out what pre-seed actually means. If you go back in time 5-7 years, long long ago, seed was really your first institution around. When I joined Softech five, almost six years ago now at this point, when I started working with Jeff, I know at Softrade a big seed round back then was probably $1.5 million, and averages were more like $750,000-$1 million. There wasn't really room for institutional capital before then, it was really angels, friends and family, or frankly nothing.
Those seed rounds were really focused on helping companies get off the ground and get traction. If you look at modern seed rounds now, I've had two companies in this month that raised seeds that were three and three and a half.
Those are classic series A rounds not so long ago, six years ago.
Ten years ago, and now those are today's seed runs and I think the market has been grasping for a term, so what do we call these rounds that happened before seed? Because seed rounds have gotten bigger, honestly because the firms that wrote those seed checks that used to be 50-50, they've all done well, they've had good demand from limited partners and they've gotten bigger. We're searching for terms, some people use pre-seed, I like classic seed, I just think it's really what seed investing has always been about and we don't yet have a new name for that $3 million seed round.
Just to clarify this follow up, does pre-seed refer to the size of the round or the stage of the company, or is it a little bit of both?
I think it depends on who you ask. I think it's more indicative of the stage of the company, but it also does have a connotation, to me most pre-seed rounds are below $1.5 million. If you cross that 1.5 threshold, you're really getting into the territory of a round that's big enough that could accommodate a seed investor that would wanted to write a $750k-$1 million check.
From our vantage here in the Silicon Valley, I would say that a pre-seed venture firm is rare these days. You usually don't hear that, that's evolved into the realm I guess like angel investors are now, presumably your kind of investors much of the time. As a consequence of that uniqueness, what advantages do you have as a result of that?
There's not a ton of people focused on pre-seed. I think one of the advantages of pre-seed and the whole reason I started Precursor is because I noticed that, as these rounds got closer to being $2 million and $3 million, it was very hard to back companies from scratch if you didn't know the founder. Two million dollars is kind of a lot of money to give to a stranger; that same $2 million check that could go to a de novo company is competing with a SaSS company that has $25k in monthly recurring revenue that you've watched grow for six months. It really becomes this weird apples and oranges discussion.
I think one of the biggest advantages of pre-seed is probably the one area in venture where there are not literally hundreds of firms with the same strategy competing over every company. I think what I've noticed is for a lot of entrepreneurs, particularly first-time entrepreneurs, are people who are not yet well known, is that raising that first $1 million is really hard. You kind of have two options. You can try to go find a pre-seed institutional firm that will lead and structure a round, or you can try to roll it up $25k or $50k at a time, and anyone who's ever tried to raise money that way knows how difficult that can be if you don't have help.
If you're a founder, you already know this if you've gone out and raised, but raising that first check, getting the first person to say yes is quite hard. Everybody likes to be in on the deal that everyone else is in on. It’s rare to have a firm or an individual who's willing to step up in a serious way, apart from the pack. To contrast a little bit, would you say there are any disadvantages compared with where you used to be, which maybe wasn't so pre-seed?
Yes, there are many disadvantages, I'll highlight a couple. One is that pre-seed funds are generally smaller, which means you have fewer dollars in management fees to spend on your portfolio and to do cool things like have an office where your portfolio companies can work with you, or put on really nice events. To my friends who are thinking about getting into pre-seed: it's the most intense way to spend your time as a VC. If you're doing your job right, you're going to meet thousands of companies in a year and you're going to invest in one or two dozen, and you're going to meet companies at their rawest stage. In general, you might meet companies that really have their act together, with a strong pitch, a strong story. You'll also meet people who are still trying to sort it out, so you have to really like the work because frankly it doesn't pay very well on a day-to-day basis, and it's a lot of effort.
The last thing is, for pre-seed to be able to work, you have to be able to get into companies at a price that reflects the riskiness of the venture. I think entrepreneurs and VCs are still trying to figure out, we know what seed rounds look like, with $2 million to $3 million in, and the corresponding valuations that make sense. We're still discovering what's a fair price for pre-seed? Is it half of what the seed guys pay? Is it 65%? 75%? A quarter? We're still doing price discovery.
Founding a startup has become a popular career choice, if at least for a spate, with millennials. For people who are legitimately working on a true pain point or opportunity, how do they distinguish themselves from all these other people who may be dabbling in startups?
It's something I think about a lot. Precursor's been around for a little more than a year, so I'm still discovering things on my own. I will say this, most of the people I back, the thing that jumps out about me is that they have a real clarity in their vision around what they want to build, and they have the next two to three steps of the journey mapped out. It doesn't mean that it's going to go exactly according to plan, and I know this sounds like a weird thing, but I find that the people I back, they have a really good understanding of the market structure. Not just the market size, but who are the competitors and what are their competitors' relative advantages? If you're building something that’s just online, you understand that your brick and mortar competitor has this huge liability called real estate. How do you use that, turn what's a weapon from their point of view, into sort of an albatross?
I tend to find I get really inspired by people who have a vision for a company that goes out 7-10 years. I think if you meet enough entrepreneurs, I'll find some people whose views are really reductive. It's like, "Oh, this is X for Y, or we're just going to take this playbook and apply it to this different area." I don't do as many of those.
I tend to get attracted to people who have slightly renegade views about the market that they're in.
If you could share, what's a good example of that, a renegade view of the market?
I invested in an autonomous delivery robotics company based in South San Francisco called Dispatch. I really like the founders, and when I made the investment, my investors said, "What in God's name are you doing with our money? Autonomous delivery robots, is this even a thing?", but the founders had a super compelling vision about why sensor technology, mapping, navigation, robotics, all these things were coming together at this one moment in time to make self-driving urban delivery a reality.
When I made the investment, I was vaguely aware of maybe one or two companies, and now there's a CB Insights table with three or four. In a year, it went from something that people were like, "Is this even a thing?" to something that’s clearly a space, and perhaps one with a big future.
Starship Robotics, Bobby, Marble—they're out there.
I think I like new areas, because in new areas, the competitive landscape isn't as well-defined and the rules for what it takes to win aren't yet known. I try to also find areas where I think there's just not a lot of competition, because those companies have more room to grow in a different shape.
Just as a follow up there, did you have a spreadsheet or a PowerPoint slide that said, "We're going to find the best on-demand delivery robot company?", or was it like you kind of discovered it and then that opened up the opportunity, that world?
I think one of the hardest questions I have to answer at Precursor is, "What are you looking for?"
I wish I could give them a really crisp: "I'm doing B2B, SaSS."
I'm people and market oriented, so I'm a generalist. The way I met the Dispatch team was actually through a relative of one of the founders. I was talking about a completely unrelated matter, and in kind of an offhand way mentioned, "Hey, I know someone who's starting a robotics company, would you ever take a look?" I think the most important thing for pre-seed is you have to be really open to new areas.
That actually seems to be an emerging trend at that stage, like Ycomet came out with some data that showed that they are agnostic to industry at that stage. I can speak for ourselves as well, that earlier stage as well, we're quite agnostic.
When looking at a startup, how do you effectively determine the market size? Especially with novel ideas, where there's not a research report that says, "The market for this thing is this big.
It's really hard. I'll tell you the way I think about it. I try to ask two questions: One, what do I have to believe about this company for it to get to $100 million in net revenue to the company. I think if you can get to $100 million in net revenue to your company, you have a legitimate business.
Do you want to explain what you mean by "net revenue"?
Yeah, so net revenue to the company, so if you're running a marketplace and you're taking 10%, you need $1 billion in marketplace transaction volume for the company to net.
The other thing is I ask people a lot about gross margins, because I tend to find people who have been thoughtful about gross margins actually have thought about, "Well what are the cost and revenue levers in my business, and how much room do I have to operate with those two?" That actually flushes out a lot of people. A lot of people say, "Well I haven't really thought about margins."
In going from working at Softech with Jeff Clavier to now running Precursor for a year and a half, do you have any reflections in terms of the largest difference for you as a VC just personally, day-to-day?
The biggest one is Jeff has invested a decade in building the Softech brand to mean something to entrepreneurs, and it is so much easier in venture when you don't have to give the pitch on, "Well, it's Precursor, it's a new firm, you haven't heard of it, let me tell you what I do." It really does help when you have a strong brand. It helps attract high-quality entrepreneurs, it helps you win deals, it helps you fight for more ownership if that's important to you, and you have the benefit of working for an institution that's been around for 10 years.
Then you leave to start your own firm and you have to recreate the brand, the back office, the brand personality for the firm. It's a lot to bite off, and I'm doing it as a solo GP, so that stuff all ultimately rests on my plate.
So are things working? You mentioned in some ways there are a couple people in this space but it's a relatively newer, in this era where B is what A used to be, A is what seed used to be, and so pre-seed's the new thing, what are your thoughts?
I think it's too early to declare it a runaway success. I look at a couple of things, like what did I set out to prove?
One, I set out to prove that pre-seed is fundamentally a different investment tier than seed. I feel pretty good about that, because seed VCs send me a lot of companies that they tell me are too early for them. I feel like pre-seed is a thing, so we can check that box.
Two, do the economics of a pre-seed firm work out? I have no idea honestly, it's too early to tell, I haven't had any big exits, I haven't had any huge flame outs yet, so it's too early to tell.
I think the third question is, "Can I help companies graduate from pre-seed to seed or from pre-seed to series A, and can the companies that I choose move through that financing funnel in a way that's economically sound?" I have seven data points that say, "Yes, it can work," where companies have either gone from a pre-seed round to an institutional seed round, or in one case from a large seed round to a very large series A.
The data is early, but the thing I learned, one of the things I learned at Softech is every quarter, the list of winners and not-winners in your portfolio, there's a lot of migration between those tiers. It'll probably be three or four years before I can definitively say that Precursor won.
How important is it for you to pick so-called "category winners?” How do you do it while you're investing at the earliest of stages?
Picking category winners is really hard. I differentiate between categories that really are winner take all. I think marketplaces in general tend to be winner takes most, so if you're the number four ride-sharing company in the US, that's a tough place to be. If you're the number four home-sharing platform in the US, that's probably a tougher place to be. I think in those, you have to have confidence that you're betting on the team that will be the winner.
I think there are other categories where the winner gets a disproportionate share but there's room for others. I think in B2B SASS, customers don't want single vendor, they want choice, but the number one company will get a disproportionate share. I just try to ask myself, “Am I comfortable backing this company knowing that I can’t back any others in the same space?"
Because you don't fund directly competitive companies.
I won't fund directly competitive companies, so I use that as a check to myself to say, "If I bet on this team, I'm forgoing the opportunity to bet on anybody doing the same thing who will come into my office in the next 12-18 months." That actually helps get really serious about, "Do I think this is the best team?"
I'll give you an example.
One area is in chatbots. Earlier in the year I met a bunch of companies in the space and I thought a lot of the founders were really strong. I was like, "I'm not ready to close the door on consumer-facing chatbots, and if I make any of these investments, that's effectively what I'm going to do." I think there will be new, stronger teams with the benefit of learning how consumers interact with these chatbots that will come later, so I passed on a bunch of things, because I thought that the real winners weren't necessarily in that set of companies.
What are some red flags that you look for? Maybe could address both sides of that question. What's a good flag, like a flag of the type of founder you would want to back and partner with? Conversely, what's a red flag?
Good things: People who are willing to admit that there are things about the business that they simply do not know. I really respect founders who will say, "You know, we haven't figured that piece out. We're still thinking that through, we have some hypotheses, but we just don't know how that's going to work out."
They have to know their market but also know what they don't know.
I like people who understand the numbers, and people who have realistic but aggressive expectations about what they can do with $1 million or less. When I talk to them about, "Well, what does the business look like in a year?", they can tell me a compelling story. It's not a data-driven story, it's a story about like, "Hey, we will have solved these three open questions about the business model, we'll have user traction on this order of magnitude, we'll have hired some people."
The number one red flag for me is co-founder who talk over each other who generally barely contain their discord in a meeting with me. You'd be surprised, maybe you wouldn't, the number of times I've seen founders talk over their co-founder and you can just see the other person seething while they're sitting there, I'm just like, "Wow."
We put out a founder guide on meeting the right co-founder, on co-founder fit. You're married to your co-founder, but they say you can't get divorced. It can happen, but it's usually kind of ugly if that happens.
If I had one more red flag, I think you have to have a healthy optimism about your ability to compete with established incumbents if you're going to do a startup, but I think my other big red flag is people who have a naïve understanding of the strengths and weaknesses of the people that they're competing against at different scale. I think you have to be respectful and informed about your competitors and what they do well. People who are too dismissive of their competition, people who brush them off by saying, "They're a big company, they'll never figure this out," or, "They're just another startup, they're not any good."
I'm looking for a little more than that.
Do founders' previous experience, demonstrated ability to build companies in the field, does that become especially important at the pre-seed, and do first time founders miss out, or is it an equal playing field for people without industry domain experience and people who are totally new to that industry?
That's a hard question to ask. That's a very good one, whoever asked that, that's a good one, because it's something I struggle with. I think that there are some industries where the lack of domain expertise can be fatal. There are some contours of digital health care, like you just have to understand there's some things you're just not allowed to do, or your company will get shut down. I also think there are some things where everyone in the industry has a pretty conventional view, and to do something revolutionary or new, you have to be an outsider.
I've made three investments in insurance companies, none of the people have ever worked in insurance ever before. I think it's because in my experience, insurance is a relatively low-NPS category, so if you were to build the insurance company that people from the insurance business would build, it's probably not going to be terribly disruptive. Take one of my favorites in the space, I'm not an investor, but I think Metromile is an amazing company. The people who built that were really smart, thoughtful market designers, not necessarily deep auto insurance folks.
It sounds like your answer to that question has a little bit to do also with what the market is, and what the founder's product or service is.
And what the strategy is. If the strategy is, "We're going to do something really different," versus, "We're going to make meaningful improvements within the status quo," then I'm looking for different teams.
You mentioned bots, are there other industries that you're kind of interested in? The way that you were kind of looking at the bot space recently, is there anything else currently on your radar that your interest has been piqued in?
I've made a bunch of investments in women's health, which is not an area that I had targeted, I had just met a handful of really impressive entrepreneurs in that space. It's funny, in venture, you make one investment and then people find out, and they assume that you like the category and founders notice, and so you start seeing more things in and around that category. I would say insurance and women's health are two where I've probably done significantly more than I thought. I came into Precursor saying I was not going to do a lot of things in and around education.
I've done a lot more in and around education than I had planned. My holdup with education has always been how do you actually get paid as a service provider? I've just recently met a number of teams that I think are either going directly to the parent or directly to the student, and they're showing even with early data that people will pay.
So they going outside the existing educational system with that?
They are, so I've ended up with more investments in that category than the original model would have suggested.
How do you evaluate startups in unfamiliar or new markets, especially international companies, so startups that are not based here? Is that something that you address? Have you funded international companies?
I have two Canadian investments, and Canada is in fact a different market than the United States in a lot of ways. I've told my investors I want to be able to visit the companies that I back and get there and come back in the same day. I just don't think I know enough about the European startup scene or the European business market or Asia or Latin America for that matter, to be a really effective, helpful investor. Even more than being helpful and effective, I just don't know what I don't know about those business environments. Typically I'll refer them to other folks that I know who are just savvier or better at doing that.