In the first part of this essay series, I discussed my takeaways on the most important internal considerations for a young investor at a venture capital firm (e.g. mentorship, defining success, decision culture, platform strategy, etc). In this next essay, I want to expand on how I’ve been trained to identify and evaluate great startups to invest in. Hope you find these points helpful!
6. Network driven investing requires incentive alignment. Pick your inner circle carefully.
Leaning on your network to learn about new companies can be effective, but not all networks are created the same. When I consider sourcing, I’ve learned that founders and rising star operators have the greatest insight on up and coming entrepreneurs since they are nodes in the most active startup communities. As a result, I constantly work to stay top of mind for these folks. Investors can be another trusted network for both sourcing and diligence, and I feel lucky to have made many wonderful investor friends in this ecosystem — scouts, angels, associates, principals, solo capitalists, general partners, etc. A big shout out goes to Adam Dawkins at Sierra Ventures for founding the Emerging Venture Capital Association and DFJ’s Jocelyn Kinsey and Maveron’s Anarghya Vardhana for co-chairing NextGen Partners — both have fostered a real sense of community amongst junior investors in my time. I’ve also hosted dinners with my partner Iris Choi that have brought a lot of awesome investors together, and they all have the most incredible backgrounds and stories!
Even so, certain folks will be more inclined to share deals with you than others. For me, angels and pre-seed investors have been natural collaborators because they want to send us their best companies to mark up! In contrast, I’ve learned to take referrals from seed and multi-stage investor peers with a grain of salt. In the best case scenario, they’ll share “hot” companies with you that are effectively on auction to the highest bidder. In the worst case scenario, they’ll share deals that they themselves passed on. These folks just aren’t going to tell you about the most exciting companies that they’ve met, and I don’t blame them! Part of this dynamic is a function of the increasing competitiveness in early stage investing as more seed funds raise capital, more multi-stage funds take earlier bets as options on future rounds, and more solo GPs emerge.
That said, venture is a collaborative industry (most deals require a syndicate of investors), and brainstorming with other smart investors focused on similar theses can be tremendously valuable(e.g. shout out to Bain Capital Ventures’ fintech guru Ashley Paston). I recommend thoughtfully developing a trusted group of incentive aligned investors that you can bounce ideas off of, share dealflow with, and be vulnerable around. The small ragtag crew I spend time with have become genuine friends, and I’d like to think we have all leveled up as a result.
7. Thesis driven investing yields the best outcomes. Make bets on the future, develop future maps, and become a magnet to founders.
The investors that I admire most are constantly learning. My partners are consistently reading and enriching their information diet based on areas they’re interested and excited by (it’s honestly hard to keep up sometimes!). I’m most impressed by folks like Bloomberg Beta’s Minn Kim, who has stayed focused and obsessed on a thesis around machine intelligence and the future of work. I believe their approach to knowledge absorption and curation is one of the best ways to build a proprietary edge in venture investing. The ability to go deep on a unique thesis means they’ll attract more relevant founders, ask better questions, and ultimately, increase the odds of making better investment decisions. You cannot be a hobbyist in thesis driven investing, you have to ultimately become the specialist expert.
I’ve learned from Mike that a thesis is best expressed in the form of a future map, or a structured way to develop and test insight hypotheses that are predictive in nature. This is distinct from a market map, which just captures the state of the industry as it is today (e.g. in 2007, a market map of transportation tech could not have predicted Uber or Lyft). The best future map framework I’ve seen comes from Mike, who has been expanding upon his approach to thesis building with his theory on backcasting. When done well, a future map helps develop a prepared mind, as well as a network of diligence experts and potential customers that will help you pick and win companies at lightning speed. The broader startup ecosystem also knows that you’re focused on a particular vertical, and the quantity and quality of your dealflow will skyrocket. I practiced this myself over the last year by sharpening my thoughts on embedded fintech. I hosted a number of virtual happy hours with product managers who touch fintech features at non-financial institutions, and founders subsequently began reaching out to get my point of view on the market!
The last thing I’ll say about thesis-driven investing is this — you’re going to get things wrong, but then the important thing is to try to understand why! We do this on our team through our Fossils initiative, where we started taking a look at Thunderlizard startups that our partnership mistakenly passed on in the past. My partner Ann and I deconstruct the insights we missed and why we missed them (e.g. Figma and Gusto were the last two covered). In being thesis driven, we’re able to both make forward looking decisions with more confidence and learn from our mistakes more clearly.
8. Leverage your own mental models for evaluating startups.
I’m constantly refining a set of mental models I’ve inherited from various mentors to help me get to conviction on startup investments. What’s worked for me might not work for everyone, but I like to use the following guidelines to determine whether or not I’d like to pound the table.
Back founders who consider their company to be their life’s work. The most compelling founders are almost never entrepreneurs “in search of a problem.” Instead, they feel an intrinsic motivation to solve the problem they’ve chosen, which I think helps them through the most uncertain moments of building a startup. I need to hear the authentic reasons why the problem a founder is solving matters to her. For example, Mark Armen, Founder of Replenysh, a circular economy startup that’s building a B2B marketplace for recycling materials, has cared about sustainability for decades. He’s spent most of his career in waste management and installed cigarette butt holders at the beach for free. It was obvious from my first meeting that his company’s mission motivated him to get up every morning.
Look for an inflection wave to ride. A very critical question for startups is “why now?” The true Thunderlizard startups that define new categories almost always ride inflections driven by a technology, regulatory, or consumer behavior change event. I want to know where a particular product could have been built 3–5 years ago, and why or why not. It’s important to determine why the current moment offers us an opportunity to uniquely win. Lyft was made possible by two inflection points: a widespread consumer adoption of smartphones and portable GPS integrated into smartphones that made it possible to accurately track two or more points in real time.
Look for the earned secret. The Thunderlizard startups we’ve worked with all have some sort of contrarian insight that the founders knew before anyone else did (or at least they knew to be valuable before anyone else did). Airbnb knew before anyone else that strangers would be willing to stay the night in the houses of other strangers, as long as they were a trusted third-party verification system in place.
Invest in products that have evidence of desperate customer love. You know you have product market fit when customers want to pry your product out of your hands. They might be willing to pay a premium to skip a waitlist because they needed your product yesterday. This is related to the depth of the pain point or moment of delight that you drive for customers. What makes us believe that this product has real love from its early customers? Caviar was one of the first online food delivery startups. Their commision and fee structure were extraordinarily expensive to start, but they knew they had real customer love when they’d still see hundreds of new user sign ups after each restaurant launch in spite of how expensive the service was. People wanted delivery!
Invest in go-to-market models with a cheat code for distribution. There’s a common startup maxim that says first time founders obsess over product while second time founders obsess over distribution. I’ve seen this to ring true and have come to appreciate founders who have clever hacks that get their product in front of customers at scale. For example, Dropbox’s early referral program, which unlocked an extra 0.5 GB of cloud storage for every friend that signs up, drove cult-like adoption.
You must believe a startup can raise a killer Series A. For enterprise software, the framework I like to use to evaluate short term milestones relates to capital efficiency. Basically, you figure out how much runway a startup will have post-raise. Generally, a founder should start telling a story to Series A investors roughly 3–6 months before they run out of cash. When they do, the company should have hit ARR equivalent to the amount that they raised, at minimum. I effectively then work backwards to determine how feasible it is for the company to achieve those metrics (e.g. dive into ACVs, sales cycles, win rates, etc). For consumer software, I’m much more interested in the trend line around engagement, retention, and virality. In either case, I need to believe the company can be set up to really hit the right metrics in the short window you have before they pitch Series A investors.
You must believe a startup has a path to a valuation that can return the fund. We use a metric called RTFE, which stands for “Return The Fund at Exit”. It’s the valuation needed at exit for a particular company to return 1X the fund’s capital, based on assumed ownership. As Mike and Ann like to say, your fund size determines your strategy. I try to work backwards from the TAM and the existing market benchmarks to gut check whether the RTFE valuation for a particular company is in the realm of the possible. I often like to pair this question with another mental exercise — what needs to be true to get this company to $100M ARR? Founders need to paint a vision of how their company becomes massive.
9. Every investment you make should be a “hell yes”. Trust your gut instinct.
I think you have to learn to trust your gut instinct when it comes to investing in companies. In each of the most exciting deals I’ve helped source and diligence in the last year, I’ve had a visceral “hell yes” moment that guided my decision process and helped me make a stronger case for the company to my partners.
This was super clear in my experience with Popshop Live — a livestream video commerce platform founded by Danielle Li (imagine if Tik Tok and Shopify had a baby). When Danielle first pitched us, two thoughts ran through my mind — how do I quit Floodgate to go join this company on the ground floor, and barring that, how do I get my own money into this company?! I literally couldn’t stop thinking about the founder, product, and insight and even woke up thinking about the business. I very rudely dragged an old angel investor friend to a follow up coffee with Danielle during our scheduled time, and within 30 minutes he was trying to win allocation in the round too!
Another illustrative example is Emotive, a conversational commerce platform founded by Brian Zatulove and Zach Wise. I was introduced to these two when we were still students — I was a partner at Dorm Room Fund and they were finishing up their last semesters at USC. For me, the thing that stood out was their exceptional ability to execute. They have this rare kind of hustle that I’ve only seen in the best founders I’ve worked with. To my shock, they were unanimously rejected by my partners and by the handful of investors I referred them to. I was literally incredulous — I had this nagging feeling that they were going to build something great. Thankfully, they pitched Floodgate shortly after I landed there (only a few months after I first met them), and we’ve been with them on a pretty wild ride ever since. They grew from $30K ARR when I first met them to $3M ARR by the conclusion of their first year! I’m a strong believer that you shouldn’t invest in a company unless you have this “hell yes” feeling. Conviction should not be lukewarm.
10. This is the best job in the world. It will also totally humble you.
This past year has been a magical one. I get to spend my days with the smartest hustlers in the world and learn about how they’re going to solve the problems they care the most about. I get to help many of them bring their ideas to life. I’m cognizant of the fact that I’ve been wrong a lot of the time, and it’ll take years before I’ll ever know that I’m right with the current set of promising startups I’m working with. Navigating zero to one with startups is a feat in defying the impossible, and it’s hard every time. Even so, this work has kept me an eternal optimist, and I am forever grateful to Mike, Ann, Arjun, and Iris for taking a chance on me here at Floodgate. Onto year two!
Paying it forward.
I’m always happy to chat with investors and founders about the art of seed stage investing. Follow me on Twitter @shawnxu to get the latest or shoot me a note at email@example.com. Looking forward to staying in touch!
Special thanks to Team Floodgate, Julia Lipton, and Minn Kim for their feedback and help in editing this piece.