How Do You Actually Know What to Invest in at Pre-Seed? 3/26

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📰 Today's Edition: How Do You Know What to Invest in at Pre-Seed?

We get asked quite a lot how Hustle Fund invests at the pre-seed stage. 

Whether you're a fellow investor or an entrepreneur trying to crack the code on how VCs think at the earliest stage, buckle up. We're diving into the messy, gut-driven world of pre-seed investing.

And yes, as a purple hippocorn, I have opinions on this. Strong ones.

Do VCs really just invest based on story and people?

Most investors will tell you they invest in the team first. ‘We back great founders’ is practically tattooed on every VC’s forehead, but that’s a problem, because very few can actually define what a ‘great team’ is.

But at Hustle Fund, we do things differently. When first reviewing decks of companies applying for funding, we don't look up the teams at all.

No LinkedIn stalking. No checking where they went to school. None of that.

"Wait, what?" you're probably thinking. "How is that not a terrible idea?"

Here's how we think about it: Getting to product market fit is the most important thing at this stage. And that starts with whether you're solving a real problem that has the potential for strong unit economics (the profitability of each individual customer). The ideas and problems come first. Team evaluation comes later, but only if the idea makes sense.

What counts as a "real problem" anyway?

Right now, I could really go for a beer. (Yes, purple hippocorns drink beer. Don't judge.) I wish there were a robot that would come into this room and just hand me an ice cold one. That's a problem I have.

But is it a problem I'm willing to pay for? Is anyone willing to pay more for it than what it will cost me to find and serve that customer? You have to factor in the cost of the robot, the delivery service, and everything else. 

Probably not. Even though needing a beer is technically a problem, it likely will have really hard unit economics that would make it viable. It would just be way too expensive to deliver a beer right into someone's hand or hoof.

So when evaluating ideas, we're looking for our gut feeling around whether this company can get to product market fit. Can they solve a real problem that fits within reasonable unit economics?

This is entirely gut-based at the pre-seed stage. No numbers. No tests. Just pattern recognition from having seen a lot of customer acquisition plays, backed a lot of companies, and run experiments to stay current with what it costs to get customers across different channels.

How much does it cost to get a customer on Facebook? How much through other channels? How hard is it to get a partnership? These factors heavily influence whether we think the unit economics will work.

Why is it all fundamentally about market pull?

Market pull means the market is just dying to buy your product or service. You can put a dollar in and get more than a dollar out. Simple as that. If you find this situation, you should be pouring money into this business.

Finding this is actually rare. Two things are important considerations for market pull:

Payback period: How long does it take to get your dollar back? If it happens immediately when you spend on ads, fantastic. For subscription products (SaaS or ecommerce), you often need enough customers sticking around to get paid back within a few months. The acceptability of your payback period should be based on how much capital you have. If you have no cash in the bank, then you cannot afford to wait six months to be paid back. 

Unit economics: If you can't make money on a single customer, you can't make money at scale. If you're putting a dollar in and only getting 80 cents out per customer you acquire and serve, this is not a good business.

Some people think upsells will fix broken unit economics. Sometimes they can, but often they can't. Ideally, your first product has positive unit economics without needing to rely on finding future products that people want and will be upsold on. 

Once a company has revenue, look at whether customers are sticking around. Are the people who signed up three months ago still using the product? How tight are the numbers?

What role does competition play in this decision?

Quick answer: quite a big role. And your competition doesn't have to be direct to hurt you.

Even if you're not head-to-head competing with anyone, if there are lots of players in the general space trying to acquire customers aggressively, you're in trouble.

I've seen this play out multiple times. A portfolio company starts with no direct competition. Life is good. Then suddenly, some large company starts pouring money into ads in the same acquisition channels.

The cost of acquisition goes up 100x, sometimes even 1000x, because these big companies don't care initially. They'll just throw money at the problem.

Even if your product is slightly differentiated, even if you're not directly competing, if acquisition costs spike because competitors are flooding your channels, you're stuck. You can't use those channels anymore. You have to find new ones, and maybe there aren't any that will product positive unit economics. 

This is why considering your competition and alternatives is important before starting your business. Too many companies think they are a unique snowflake, while my mother told me there are plenty of purple hippocorns just like me being manufactured from China. 

So what do you look for? 

We very much see investing as akin to surfing. You don't want to be too early on the wave and you don't want to be too late. As a result, we like to invest in markets that are relatively nascent and may even be small when we're investing. 

Part of our investing bet is that we believe the market could grow to be quite large within the next few years. And as a result of this dynamic, there may be little to no competition in the beginning because most people do not think the opportunity is lucrative, but we expect competition to come in within a couple of years and that the teams we back can get a decent enough head start to run at the problem. 

This is why a lot of investors ask “Why now”? I, as a purple hippocorn, used to think this was a stupid question, but if you believe the world is filled with billions of smart, ambitious, hungry people (and hippocorns), there’s got to be a reason why an opportunity wasn’t already solved 3 years ago if it was possible to do so. So riding on the trends of the current day is often a good way to find the right opportunities. 

What should you take away from this?

Pre-seed investing is fundamentally about finding ideas that can reach product market fit with strong unit economics. It's less about pedigree or story and more about whether the fundamental business model makes sense and the market landscape makes sense.

Focus on proving you can solve a real problem within reasonable unit economics. Show that you understand customer acquisition costs and how unit economics work. Demonstrate that your solution isn't just wanted but economically viable. And remember why now. 

Until next time,

Dunky, the "market pull" flying hippocorn

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