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.
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:
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, weather 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:
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:
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:
I often say that the Calm Company Fund 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.
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.