RSCM is different from the vast majority of startup investors.
We are one of the only ones that is completely transparent on our Web site about our criteria and completely open access to any founders that think they meet them. Then we are fast. We make decisions in days and fund in weeks
If you’re familiar with how other investors work, you might find our behavior confusing. But once you understand our perspective, you’ll hopefully appreciate the rationality of our approach.
We look at the investment process like engineers:
- There are very large numbers of both startups and investors.
- The probability of any particular startup and any particular investor overlapping in their requirements is small.
- Startups and investors both want to find the best match.
- Time is valuable.
Conclusion: as an investor, (1) you want to be very up front with your target profile so startups outside this target don’t waste their time with you and (2) if you’re going to pass on a deal, you want to do so as quickly as possible. The later in the process you pass, the higher the cost to you and the startup. If you fail a high percentage of deals near the finish line, you’re doing it wrong.
When we analyzed and observed other investors, it seemed like two large sources of rejection frequently occurred at the very end of the process: outside of scope and disagreement on valuation. Investors would spend an enormous amount of time learning about a startup’s technology, business, and team, only to say, “No,” because they didn’t feel the investment ultimately matched their thesis or the founders wanted too high of a valuation.
To address the first category of failure, we made a list that defined our ideal profile and stuck to it. That may sound simple in theory, but it turns out to be extremely difficult in practice due to “fear of missing out”. Our goal was to come up with a set of criteria so crisp that we would never invest outside its boundaries and would invest in anything within its boundaries at the right price. Obviously, such perfection is impossible, but we are far closer to this ideal than everyone else.
Our list is not very long:
- Must be a “technology startup”.
- Must be “capital efficient”.
- Must be looking for an investment of no more than our maximum round size.
- Must be looking for a valuation of no more than our maximum valuation.
- Must be located within our investment geography.
- Must not be in one of our excluded business areas.
- Must meet our minimum traction bar.
- Must have a minimum number of FT founders..
Obviously, the parameters of each requirement can evolve. But it’s easy to declare them at any point in time, at least for (3)-(8).
Defining a “technology startup” is more subtle. For example, Internet auction sites and bookselling sites were “technology” in 1995. In the 2020s, not so much. What about a company that makes clothing from advanced materials manufactured by someone else and then sells it on Amazon? We would look at this business and conclude that their value add is the design of the clothing, so it’s fashion not technology. A similar analysis applies to resellers, who may sell extremely technical products, but their specific value-add is not the technology in those products.
Then there’s the issue of “technology-enabled” businesses–ones that apply technology internally to deliver a non-technology product such as car repair or temporary workers. In these cases, we consider how much technical advancement the startup has achieved and whether its business is likely to scale dramatically better than it would without the technology enablement. For example, if the technology enablement were superficial and easy to imitate, we would be a no. If the business required building or customizing specialty facilities at scale, also a no. If the differentiation were branding or fashion, no.
In general, we try to predict whether the business would scale rapidly due to its technological advantage and whether the exit market would treat the business as technology, with its associated high valuation multiples. Obviously, these touchstones are imprecise, but at least they provide a framework for making a determination.
The definition for “capital efficient” is also fuzzy. The underlying issue is that, the more capital a company needs to prove out its business, the more vulnerable it is. Also, when you’re an early investor that doesn’t follow on, there can be structural challenges with large subsequent rounds that occur before a company has achieved product-market fit. The question we ask ourselves is, “Could this business reasonably get to breakeven, if necessary, with only $1M to $2M in total investment?” That doesn’t mean we don’t want companies to take more money; we just want them to have the choice and negotiating power of not needing large future rounds.
Valuation Up Front
Addressing the second challenge of avoiding mismatched valuation expectations is trickier. Any solution requires calculating at least a narrow range for the acceptable valuation up-front and at low cost. Initially, we developed a basic algorithm using parameters like founder experience and stage of technical development. This algorithm worked well enough to make us far more nimble than other investors, but required substantial qualitative judgment to determine the input value for each parameter.
Then, a few years after we started investing, startups in our price range started routinely having initial revenues. We quickly realized that we could key valuations off these revenues. While more objective than our first algorithm, this path presented two sub-challenges.
The first sub-challenge was determining whether focusing on revenues would produce “negative selection”. It’s theoretically possible that the startups with the most potential to have very high returns are those working on groundbreaking products that take longer to reach a salable stage. In fact, there was also some conventional wisdom to this effect. However, there was also conventional wisdom from the “Lean Startup” movement that advocated getting some version of the product into the hands of customers as soon as possible.
When we analyzed our portfolio up to that point, we determined that several factors argued strongly for early revenues being a net positive:
- Burn. Startups at our stage seemed to typically burn $10K to $20K per month. Revenues of even $5K per month could extend runway 33% to 100%. Because we fundamentally believe that the earliest startups represent option value, revenue that extended runway should increase this value.
- Business. Having some customers willing to pay something is a positive sign that the startup is in a general area that might be a good business. Also, founders that are able to convince people to pay now is some indication that they’ll be able to convince people to pay more in the future. Finally, achieving initial revenue quickly and at relatively low cost is a signal of capital efficiency.
- Innovation. Having customers to test new features on and ask about broader needs is a valuable source of insight. People who pay money are a more reliable source of opinion because they have skin in the game.
The second sub-challenge was how to deal with different revenue models. Obviously, a company that sells a piece of hardware at 50% margin and then a bunch of professional services is quite different from a SaaS company with customers on annual contracts at 90% margin. After reviewing our portfolio to that point, we were able to construct a set of rules that accounted for these differences:
- Only revenues from the technology product or service count. No professional services revenues.
- Only gross margins count.
- Growth path matters. A startup that reaches $10K/month in three months since launch is more attractive than one who took a year to grow from $1K to $10K.
- Recurring matters. Customers on annual contracts are better than ones on month to month contracts, which in turn are better than those who pay once. Generating revenues from a spot market, such as an ad or affiliate network, is the least attractive.
- Price point matters. At low price points, the sales channel must be very scalable and the acquisition costs pretty low. At higher price points, there is more room for error.
- Sales channel matters. The lower cost and more scalable the channel, the better.
- Acquisition cost matters. The less it costs to acquire a given amount of revenue, the better.
- Revenue concentration matters. Having more than one enterprise customer or customer segment is more attractive.
With these rules, we can look at a startup’s revenues in the context of our historical deal flow and determine our valuation tolerance. Obviously, if we happen to have several recent deals with identical revenue characteristics, we can determine the valuation easily. But the above rules also allow us to make tradeoffs versus recent deals with different characteristics. For example, a company that is otherwise similar at half the price point would be worth a modest amount less. But if it had achieved revenue more quickly then grown much faster, that could make up the difference. In practice, we seem to be able to make these tradeoffs for most startups we encounter.
Importantly, we distinguish between the “market” price and the price we are willing to pay. While we may determine that the market price for a startup is X, that price is based on the startup going through the much lengthier, haphazard, and opaque process other investors use. So we typically ask for a price that is 20-30% below market. Conversely, we acknowledge that startups can likely get a 20-30% higher price if they are willing to go through that longer haphazard process. Note that this position makes us a more competitive choice for startups that don’t have a lead investor or a substantial fraction of the round closed. Startups that already have a chunk of working capital coming in obviously don’t get as much benefit from us moving quickly.
These two innovations, sticking to an ideal profile and aligning valuation expectations up front, lead to a straightforward, efficient investment process. We simply apply the concept of failing as fast as possible.
- Receive request. We funnel all funding requests through our Web site to ensure we get a relatively consistent set of information that we can process quickly. Sometimes, we receive an electronic or verbal inquiry where we can “look ahead” to identify an obvious mismatch and save a founder the trouble of going to the site.
- Screen for profile fit. Based on a company’s description, Web site, and deck, we try to determine if a company fits our ideal profile. Occasionally, making this determination may require a few emails.
- Screen for valuation fit. Based on a company’s revenue model, current revenue level (including firm contracts going active soon), and capitalization structure, we calculate our valuation tolerance. Sometimes, making this determination may require a few emails.
- Make an estimated offer. If a company’s valuation expectations are far outside our tolerance, we often reject the deal out of hand. If there’s potentially some room for overlap, we will provide our estimated offer to the company. Sometimes, exploring whether there is overlap may require a few emails.
- Review initial diligence documents. If there’s a profile fit and valuation alignment, we’ll review an initial set of diligence documents. We usually want to see a capitalization table, current balance sheet, monthly P&L spreadsheet, and some breakdown of customers.
- Phone call. If the documents don’t present any red flags, we schedule a phone call to review the business in general and dig down on specific issues. Often we proactively schedule a phone call for a few days after the company’s estimated date for delivering the documents.
- Make confirmed offer. Within 2 business days of the phone call, we make a confirmed offer or final rejection. We almost always make our offer based on a YC post-money SAFE with a cap set to our pre-money valuation plus the round size and a discount of 20%. In cases where there is a specific reason to use a different type of instrument, we can be flexible.
- Final diligence. If the company accepts our offer, we proceed to final diligence. Unlike some investors, final diligence is not about figuring out whether there’s a good fit. Rather, it’s about verifying the information previously provided, as well as generally making sure the company is legally and financially squared away.
- Execute investment. Once final diligence is complete, we generate investment documents, execute them, and then wire.
Typically, steps 1-4 take hours to days. The whole process requires 3-4 weeks from first contact to wire–if the company is responsive, has the necessary documents at hand, and there are no scheduling issues. 2 weeks is sometimes possible. The most common causes of delays are the company not having all the necessary initial and final diligence documents or there being some sort of circumstance that needs correction before we can proceed, such as converting to a C corporation.
We often see other investors taking 3-4 months, sometimes longer, even in the good case. Moreover, we often see those investors saying, “No,” several months in.
Internally, because our process always has a well-defined next step with a well-defined decision making scope, we rarely find ourselves getting bogged down. If we do, or if we end up having to say, “No,” late, we try to identify the underlying cause and fix it if possible.
Given this approach, we’ve found that it helps for founders to keep the following in mind:
- Meetings are late in our process. Just because we don’t take a meeting early, doesn’t mean we’re not seriously evaluating an opportunity. Scheduling introduces calendar delays and limits the number of startups we can work with at any one time. Luckily, we can collect the vast majority of information we need for a decision without a meeting. When we take a meeting (usually by Zoom), you have already checked off many of our boxes and we have concluded a fit is likely.
- We care about the details of your revenues and unit economics. Because revenue is our number one metric, we tend to dig pretty deeply into the details of each revenue stream and its associated economics. We’re essentially trying to build a model of how your business generates gross margin.
- We care less directly about your vision and team. Other investors will often spend a lot of time trying to assess your vision and entrepreneurial spirit over several meetings. While we do care about vision and team, we are humble about our ability to assess them just by talking to you, so let the early results mostly speak for themselves.
- The more organized you are, the faster the process will go. However, we are patient. If, for whatever reason, you don’t have everything nicely organized, it usually won’t stop the deal. With a well-defined process, we can hold an investment at any stage while issues get resolved. In fact, we often help companies overcome obstacles during the process. But we would sincerely prefer to complete the process as quickly as possible so founders can start putting our investment to work in their businesses!
- We care about speed. We want to be fast so you can be fast. First, we want to get you back to the business of building your business. Then, once we’ve invested, we want you to have the resources for faster sales, marketing, and future fundraising.
In general, we see ourselves as less judgemental and more process driven than other investors. The goal is not to holistically assess each company and pronounce it a “good deal” or not. Rather, the goal is to systematically build a large portfolio of companies in a very specific area of the market. Just because a company isn’t in our target area doesn’t mean we don’t think it will succeed.