How does a VC invest in a startup that doesn’t exist yet? According to Elizabeth Yin, it boils down to four factors: the idea, customer acquisition, lifetime value, and sales cycle.
Yin is a co-founder and partner of Hustle Fund, a Bay Area-based venture capital firm specializing in “hilariously early” startups. Hustle isn't your typical venture capital firm — instead of throwing millions to established companies, Hustle writes small checks to pre-seed startups. The average check is around $25,000, designed to help founders get their brand new businesses off the ground. As for Hustle’s own funding, the firm just raised $33.6 million for a second fund, which it plans to invest in some 300 companies.
In a recent Twitter thread, Yin outlined what makes a pre-seed startup worth investing in (spoiler alert: it’s not traction).
1. The idea
The first key to success, says Yin, is the idea. In fact, contrary to conventional VC wisdom, the idea is more important than the founders who came up with it — at least in early stages.
“I've just seen so many amazing founders — almost because they're so amazing — make a bad idea work out mediocrely successfully when if they had been working on a great idea, it would have gone spectacularly,” Yin wrote. “It is always more fun to push a boulder downhill than uphill.”
Yin also knows what happens when mediocre founders have a great idea. “Product market fit is a spectacular thing,” she added. “These founders can attract a lot of talent, because the business has a lot of market pull.”
2. Low customer acquisition cost
Perhaps the most important factor that Yin looks at — and spends the most time discussing in the thread — is customer acquisition cost (CAC). According to Yin, marketing is eating the world, and marketing to new customers shouldn’t cost too much.
“CAC is driven by competition,” Yin wrote. “Direct competitors as well as indirect. Competitors run up CAC in marketing channels. As well as in mindshare. For example, everyone gets TONs of emails. Which ones do you read? The Macy's newsletter might get archived while Morning Brew doesn't.”
Yin used Clubhouse as an example of a platform that rose above the noise to gain traction. Since its launch last April, the platform has grown to 10 million weekly active users. Yin thinks Clubhouse’s path to success was its low CAC, as well as utilizing its VCs — and tech celebrities like Elon Musk — to promote the platform.
3. High lifetime value
In addition to CAC, Yin looks at how long those customers may stay with the startup, and how much revenue they’ll pull in, otherwise known as lifetime value (LTV). High LTV comes with time, so Yin can only speculate during the early stages of a startup. Some of the questions she asks are: “Could this solution be valuable enough so that someone will pay a lot for this? and often? And how valuable? Or is it just a nice to have. Or maybe only use for a short period of time. Retention is a big factor and high retention drives up LTV.”
4. Sales cycle
Then there's a company’s sales cycle. Many early stage startups need revenue, or at least a generous funding round, to keep going. If Yin sees a great startup that needs more money than Hustle can offer, it’s not a great fit. But a company that only needs a little push to get off the ground might see cash coming in sooner than an enterprise software startup, says Yin.
Yin concluded her thread by saying that her approach isn’t the same as that of many VCs, including the ones she works with: “And that's great - there's no right or wrong.”