Many conversations I’ve had with limited partners, fellow investors, and portfolio company founders have centered around navigating the current environment. Given the level of uncertainty, many of these conversations come down to how people are making decisions, given how unsettled things feel. In many cases, people share the rules they use to make decisions. A few examples of the rules I’ve heard from folks:
- “We are a pre-seed fund that will only invest in companies with revenue in this environment.”
- “We want all of our companies to have 24 months of runway, at a minimum.”
- “We have to get to $1 million in revenue to raise our next round.”
I understand the desire to have rules for decision-making. Rules are a handy way to make decisions, as rules can help reduce cognitive load and provide a framework for what to do and when. But in times of great uncertainty, rules can give you a false sense of security.
Rules can be good guideposts, but the rigor of rules creates opportunities to game the rule. It is much harder to game a well-articulated principle.
When I look at the above rules, I understand their logic and why they might be useful and helpful. For each of those rules, though, I think there is a better principle that would help make better decisions. I rewrote them with some commentary:
- “We are a pre-seed fund that invests in companies where we have clarity on how the business model works and how the company will generate revenue.”
- ”We want to make sure our portfolio companies have the necessary capital to meet the milestones they need for the next round.”
- ”We need enough revenue to demonstrate that our model works before we can raise another round of capital.”
An important skill in pre-seed investing is the ability to spot great companies early. Some of our best investments were in pre-revenue companies and we’ve had companies that had revenue but failed to scale. The original rule would likely keep you from investing in promising early companies and might steer you toward people with early traction but limited upside.
Capital is like oxygen; it allows you to breathe and stay alive. But capital alone won’t help you find product-market fit or validate your hypothesis. A long financial runway for a company with a flawed core premise or idea might not be able to overcome that issue no matter how much runway they have. Conversely, other companies might be so close to unlocking the next round that they don’t need a two-year runway. Focusing on runway over the needs of the individual company can lead to focusing on the wrong thing.
There is no magical threshold amount of revenue that will unlock a round of financing. Revenue is just one of the many things investors consider when evaluating an investment. The more important principle at work here is that revenue is often (but not always) evidence that a company has a working model. Having a working model that could lead to a big company is much more important than some arbitrary amount of revenue.
If you find yourself grappling with a difficult decision and you find yourself looking for a simple rule or framework, I would encourage to take a beat and make sure you understand the principle behind the rule before you apply it.