Aileen Lee is the founder of the seed-stage focused venture capital firm Cowboy Ventures. She was previously a partner at Kleiner Perkins Caufield & Byers. Lee was also the founding CEO of the digital media company RMG Networks. She is a graduate of MIT and Harvard Business School.
- “Venture investors are looking for large addressable markets. How big is the market? What is the problem that you’re trying to solve? Who’s on your team? And how relevant is the team to that problem? What is the product that you’ve built, if you have built something? Or what do the wireframes look like? What kind of traction or feedback have you gotten from the market in terms of whether people are going to like the product, or whether they do like the product? What does the financial model and the economic model look like? What are you going to do with the money?” “What is the mission and vision of the company? Venture investors are looking for a big mission and vision that’s quite ambitious and that can be backed up by, ‘Here’s where we want to be and here’s how we’re going to get there over time. This is what we want to get done the next 12 months or the next 18 months.’”
Aileen Lee is identifying what she looks for in a startup which is useful to know if you are trying to raise funds for a startup. Marching through these factors one-by-one is a helpful exercise. Some of these factors are depicted below in a Venn diagram format I borrowed from a recent tweet by Semil Shah of Haystack. In my diagram “X marks the spot” that a business wants to achieve. Of course, it will not look exactly like this in terms of balance in each case.
Lee and other venture capitalists are very focused on the potential size of the addressable market targeted by a startup which is the first factor. Pioneering venture capitalist Don Valentine describes why this is such an important factor:
“If you don’t attack a big market, it’s highly unlikely you’re ever going to build a big company.” “Great markets make great companies.” “We’re never interested in creating markets – it’s too expensive. We’re interested in exploiting markets early.” “I like opportunities that are addressing markets so big that even the management team can’t get in its way.”
The second factor is people. Who are the people involved in the startup and how strong and cohesive is the team? The team is unlikely to be complete at seed stage but has the team there now shown that they are compatible? Are diverse personalities and skills part of the team? The people involved need many capabilities and skills. For example, do they have genuine zeal about solving an important problem for customers? Are they missionaries or mercenaries? People who do not deeply care about the mission of the company are significantly less likely to produce the desired financial returns because they are more likely to quit when they inevitably face challenges and are not motivated to work as hard.
The third factor (product) is obviously important for a venture capitalist, but often the product has only been vaguely defined at the time of a seed stage investment. Even if a product does exist it will inevitably change after a seed round investment is made as the business tries to prove that it has discovered product/market fit. In short, the earlier a venture capitalist invests in a startup the less developed a product will tend to be. This means that seed stage investing is more about people and markets than at a later stage. In other words, not all parts of the above Venn diagram will arrive at the same time.
- “We love to see, ideally, some kind of technical angle, or a technical solution.”
Every business must eventually find some sort of sustainable competitive advantage to be profitable. At the seed phase of its existence a startup will also have less defined business model and unit economics, but an investor can still have a sense of what these aspects of the business may ultimately be. Among the questions the seed stage investor will begin to ask are: What will the business do differently than its competitors? What sustainable competitive advantage can the business create versus competitors? Is that differentiation sustainable in the face of competition? Is the business scalable and does it have a tailwind? Another Venn diagram that is nested within the product category like a Russian doll looks like this:
The best sources of sustainable competitive advantage in today’s business world are found in technology through phenomena like network effects.
What you are looking for in addition to s sustainable competitive advantage is a tailwind that will help the business prosper. Moore’s law is an example of a phenomenon that produces a tailwind for many businesses. Warren Buffett says that the success of a manager is more determined by the favorable nature of the boat they get into than their skill as a pilot. He does not mean that skill as a pilot is not hugely valuable. Great execution in a business really matters, but he is saying: “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.” The best of all worlds is a business with great economics and a management teams with fantastic management skills.
People working in a technology business often do not fully realize how much harder life for a business is outside the markets where they operate. I frequently look at a business outside the technology world and think to myself: “My god these margins are tiny. How do they survive? There is no margin for error at all.” Some of these businesses may even seem sort of romantic in a hipster sort of way, but they operate on razor thin margins. Lifestyle businesses are often crowded since they are, well, a great lifestyle.
- “Spend the first six to 12 months building a great product or service that people love, rather than chasing investors. When the time comes to engage investors, you will be meeting them from a position of strength. This makes all the difference.” “We usually suggest that your seed round lasts you at least 18 months, if not 24 months, or more than that.” “On the financial plan, the bar has been raised in terms of how much Series A investors want to see you accomplish from seed stage before you raise A, and then from A to B, and B to C.”
It is wise for a founder to have enough financial slack so that the business can iterate but not so much capital that people try to potentially fatal things like scale the business prematurely, broaden the scope of the product too far or pivot too often. Financial constraints are a part of what drives creativity. Solving problems with just money does not scale or generate attractive financial returns for founders, employees and investors. The more money that is invested in a startup, the more importance investors will assign to hitting milestones and the less they will make the decisions based on instinct. Milestones worship can be taken too far. The venture capitalist Tom Tunguz complains: “Today, demo days are a misnomer. We should call them metrics days. Market size. Weekly growth rate. Net negative churn. The same is true for fundraising pitches.” He would like to see an actual product demo more often.
There is no more important milestone for a startup than product/market fit. I have written more than one long blog post on this topic, but a simplified version of that would be to say: A startup will know it its offering has achieved product/market fit if they are having trouble meeting demand for the product.
- “There’s a saying that the definition of ‘entrepreneur’ is being able to do more than anyone thought possible with less than anyone thought possible. That’s the ticket. You do not have to have a Ph.D. from MIT. It’s about what can you get done with the little you scrap together.” “At seed stage, you do not have not enough time, not enough money, not enough people.”
What Lee is saying about the resourcefulness of a great founder reminds me of a comment that Jeff Bezos made about what he was looking for in a wife: “I wanted a woman who could get me out of a Third World prison.” Investors love founders who are resourceful. The best investors know that unnecessary speeding causes unnecessary equity dilution but even more importantly they know that founders who spend money on frivolous things wastes precious resources that may determine the difference between life or death for the business. A strong company culture and work ethic combined with resourcefulness and innovation are keys to building a solid business and equity value. The best way to solve problems is with innovation and company culture.
- “Founders generally want advice, or help, or guidance, on multiple fronts. One is on hiring. Many times a founder has never hired certain types of people before. They’ve never hired a head of sales, or they’ve never hired a UX designer.” “As a founder, one of your most important skills is as a recruiter, as an identifier of talent and a curator of talent. If you hire the wrong developer or you hire the wrong UX person, you could run out of time and make a product that nobody likes to use. It’s really about attracting a lot with very little resources.” “There are a lot of benefits to having a team of young people, but there are many benefits to having people who’ve made a lot of mistakes.” “A lot of [venture investing] it is about the people. And so high integrity, high intelligence people, who have also shown a certain amount of hustle and scrappiness in figuring stuff out before they raise money, and then having kind of an aggressive but doable plan for what they’re going to do with the money, and within a reasonable period of time.” “Relevant backgrounds, if possible, or at least a personal connection to the problem that the person and the team is trying to solve.”
Someone who does not know how to sell has a significant handicap in building a successful business since one of the most important tasks for founder is to sell the best people on the future of the business. Founders often underestimate how much of their time will be spent recruiting great people to work at their business. The earlier the hire happens the more it will shape the company culture and the greater the fallout of bad hire will be. The impact of a bad hire can be enormous. It is not uncommon for a founder to spend more than 50% of their time recruiting people at the seed stage of the business.
- “If someone asks you questions [during a pitch meeting], take notes, and send a follow-up the next day saying, ‘These are the things that we discussed; I wanted to follow up on these points.’ Show that you’re super-conscientious, and you’re on it.”
Investors like to work with founders who are responsive and organized. First impressions and small details matter, especially when an investor has little data on which to make decisions. As an analogy, when I am interviewing someone and he or she treats people they consider to be “staff” poorly or do not clean up their own mess, they will always get a “do not hire” from me.
What a founder wants is an investor who asks great questions and does not waste their time. If all a founder gets from an investor is money at the seed stage, they are wasting a big opportunity. Professional seed stage investors are much more likely to be value added capital. Raising money from you Uncle Louie may be easier and done at a lower valuation, but in the end that can be very expensive money.
- “It takes a long time to build a big company and companies have ups and downs, so you know that you are in year two of a ten-year journey, and you wish you knew how the movie was going to end. But that’s the deal with working with startups. The journey is the beauty of it; it’s not about the end. But, still, sometimes you wish you knew how the movie was going to end.”
The time scale over which an investor will obtain feedback from a seed stage investment is the longest in the venture capital business. Financial exits may not happen or 10 or more years after the investment is made. The time scale over which a seed stage venture capitalist might see a return from their carried interest is so long that some people you have read about have not yet received a distribution of carry. If you do not love working with young companies, there are more financially attractive ways to make a living than being a seed stage investor. You may find that like the Tom Petty song lyric that “the waiting is the hardest part.”
- ‘For most companies, month on month (MoM) organic growth is a very useful metric and depending on the base, 20–50% MoM growth can be good. Retention, referral, and churn are all things we look at, too. ‘If someone asks you, ‘What’s the CAC, what’s the LTV, what are the margins, what’s the revenue plan for next year,’ just know it. Practice it.” “You can’t get into the trap of paying for customer acquisition.”
Lee is describing one type of milestone for a business, but she is also saying that the most valuable customers are acquired organically. Customers acquired without paid advertising (e.g., by word of mouth) churn less, stay customers longer and generate more revenue. Acquiring customers inorganically with paid marketing too often is hiding the fact that the product really does not have product market/fit. Tracking these and other unit economic variables is critically important since otherwise the business and investor do not know whether their model is scalable. When you run a financial model of the lifetime value of the customers of a business you will often see that the benefits of retention are nonlinear. In other words, the highest return on investment in generating new growth is often not to shrink.
- “Cowboy Ventures is still kind of a startup. I had been at Kleiner almost 13 years. At large firms [like Kleiner], just like large companies, as you get into senior management, you spend more and more of your time in meetings, less kind of doing the functional work, and more around kind of trying to help run the firm a bit. I just really love working hands-on with founders and with portfolio companies.” “We always co-invest with others, and I really enjoy that. I really enjoy that and hope that does not change. I think that’s the way Series A used to be, firms used to split Series A rounds. But over the years, firms wanted more and more ownership, so it’s become more binary. I really like that seed is a more collaborative phase.”
Maintaining personal sanity while engaging in seed and other early stage investing requires a unique personality. The earlier the investor writes checks the higher the business mortality rate will be. I wrote about this aspect of seed stage investing in my blog posts on Jason Calacanis, Steve Anderson and other investors. Calacanis describes his math in this way:
“It’s a portfolio strategy. If 7 out of 10 fail, 8 out of 10 fail, what you’re trying to do is figure out what those 2 out of 3. Let’s say 2 or 3 out of 10 don’t fail. You want to quickly figure out who those 2 out of 3 are, and then take your 25k investment and make a 100k investment in those 3. Then you figure out, let’s say you’ve done 100, and you have 4 of them that are really breaking out, you want to figure out which those 4 are, so you can put 250k into those. On a name basis, 7 out of 10 of your investments fail.”
When any given business in a portfolio fails it will inevitably create some chaos. When this is constantly happening that creates even more chaos. Being calm proceeding through that seed investing storm is not something everyone can do well. Remaining optimistic while this is happening is not something that everyone can do well either.
People like to talk about seed stage winners, but most startups are buried in the dead of night in unmarked graves. The names of the startups disappear from the web site of the investors silently and unceremoniously. Making a decision to no longer invest in a business on a regular basis is non-trivially hard.
- “The math of venture capital is such that venture capitalists make money through a combination of fee income and what is called carried interest, which is basically profit sharing with their investors once you’ve returned the capital. And when you do the math on funds, if you have a $500, $800 billion, $800 million or a $1 billion fund, the number of multi-billion dollar companies that you have to be an investor in per fund is quite large. When you do the math, it seems very unlikely that most venture capital firms will be able to generate the kinds of returns to investors and to themselves that they have in the past. The math, I think, just works much better, and it’s much more aligned with entrepreneurs if the funds are smaller.” “Venture is a decades-old, multi-billion dollar annual industry and yet there has been a surprising lack of data and quantified learning about what drives the best results, the ‘making of’ so to speak.” It was inevitable that a business-like venture capital which funds many startups which employs many data scientists would itself be increasingly analyzed using those same tools and approaches. The amount of performance data provided by PitchBook, Cambridge, and CB is more detailed and specific than ever. In this new data driven world it is harder to hide since there is a diverse group of people slicing and dicing the data on the venture capital industry. Decisions can now be made on a more objective basis by startups and limited partners.”
As Charlie Munger likes to say: “I have nothing to add.” Lee explains her view on this math well enough already and this post is getting too long.
- “Why do investors seem to care about ‘billion dollar exits’? Historically, top venture funds have driven returns from their ownership in just a few companies in a given fund of many companies.” “In every fund of 30 companies, there will be one to three mega-hits: giant winners that return the capital of the fund and then make great profits for both the people who run the fund and the investors in the fund. And all the other companies are drops in the bucket, but it’s really about a couple winners that are worth a billion or more?” “Traditional venture funds have grown in size, requiring larger “exits” to deliver acceptable returns. For example – to return just the initial capital of a $400 million venture fund, that might mean needing to own 20 percent of two different $1 billion companies, or 20 percent of a $2 billion company when the company is acquired or goes public.”
A seed round investor like Lee has different numbers to work with than a venture capital firm like Kleiner. Again, I have nothing to add.
- “Valuation is not the end. It’s a means to an end. It’s a nice milestone to show that you are making progress in terms of building a company to scale.” “It’s really hard, and highly unlikely, to build or invest in a $1 billion company. The tech news may make it seem like there’s a winner being born every minute — but the reality is, the odds are somewhere between catching a foul ball at an MLB game and being struck by lightning in one’s lifetime.” “Relative to all the start-ups out there, getting a valuation of $1 billion is rarely accomplished.”
When I decided to write a post about Lee I made a conscious choice not to spend much time writing about her creation of the term “unicorn.” That topic has been discussed enough already for another rehash of that topic by me to be valuable. I decided to write about Lee’s views on what it takes to create a successful business, a process that she clearly loves. Writing or talking about valuation before describing what is needed to create a business is to put a horse in front of a cart. The venture capitalists I admire most are roll-up your sleeves and work people like Lee, instead of fickle cheerleaders who turn and run at the first sign of a problem.
End Notes:
https://pando.com/2017/01/24/cowboy-ventures-aileen-lee-hiring-ted-wang/
https://blog.ycombinator.com/aileen-lee-and-kirsty-nathoo-at-the-female-founders-conference/
http://www.huffingtonpost.com/quora/cowboy-ventures-founder-s_b_9307128.html
Techcrunch: http://techcrunch.com/2012/04/06/kleiner-perkins-aileen-lee-seed-funding-interview/
Pando: https://pando.com/2012/04/06/kleiner-perkins-partner-aileen-lee-starting-a-new-seed-fund/
NYT Unicorns: http://bits.blogs.nytimes.com/2015/07/05/unicorns-a-fitting-word-for-its-time-and-place/?_r=0
Welcome to the Unicorn Club http://techcrunch.com/2013/11/02/welcome-to-the-unicorn-club/
Entrepreneur Wiki http://entrepreneur.wiki/Aileen_Lee
San Jose Biz Journal http://www.bizjournals.com/sanjose/news/2014/01/13/vc-aileen-lee-on-rarity-of-1b.html
Samir Kaji: https://www.cbinsights.com/blog/past-present-future-micro-vc/
Fred Wilson http://avc.com/2009/04/the-venture-capital-math-problem/
Pitchbook: https://pitchbook.com/news/articles/the-bubble-hasnt-burst-vc-is-just-taking-a-pause
- Business Lessons from David Chang (Momofuku Noodle Bar and Food Television Personality)
- Business and Life Lessons from John Cleese
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