Part 2 - How I Underwrite Founders and Opportunities: Understanding Markets and the $100M Question
This is part two of a four-part series on how I approach underwriting founders and opportunities. In part 1, I covered why people always come first. This week, I dive into understanding markets and determining venture scale.
Understanding the Market (And Fragmentation)
Part 2 is seemingly straightforward: Do you understand the market you’re building for? It may seem wild that I even need to mention this, but I constantly see more traditional tech and VC folks underestimate the complexity of selling into old-line industries. Maybe in a wild and rare case, you can make an argument that a true outsider’s approach is a good thing. But in most, it’s like throwing money on a BBQ.
In many of the spaces I invest in, founders are selling into hyper-fragmented markets. Some of this is simply that the industry is outdated, and so are its processes. However, in other cases, there are genuine reasons for why they operate the way they do. Don’t underestimate the reasons for fragmentation and the value it may provide to operators in the industry.
For instance, in construction, people need to be close to their job sites, and so do materials — a carpenter can only service things he can drive to and touch. He can't repair a porch remotely (Although maybe that changes with humanoid robots). But today, he needs to be present to drive the nails and cut the wood. If you’re selling software to HVAC repairmen, you need to understand that their market is within 30 miles of their technicians. Offering them a solution that doesnt take that into account won’t excite them — it’ll just show you don’t understand their business. Things like this are so well understood within the industry that people don’t mention them explicitly. Founders need to know this. It’s like me telling you to breathe before doing an exercise — I expect you to know that you need oxygen.
For many of these companies, they don't actually need your software. Yes, it may make their life easier, but easier, and necessity are not the same thing. Do you understand that? I want to know, how are you uniquely able to get them over the buyer's hump?
This is just one example of what I’m trying to answer when meeting with a company. And, because I am focused solely on the sectors I invest in, I either know the market you are selling into well or can check into it via my network quickly — part of my due diligence process always includes this, and if I know the market better than you, that is an immediate red flag.
A real-life example of this happened last year. I passed on a company in the construction space that went on to raise well over 30 million dollars — before eventually going to zero. It raised money from some of the biggest names in VC. But because of my background in the space, I immediately saw they didn’t understand the process they were selling into. Worse, it was also clearly evident that they had no desire to consider why things might be done in a certain way. The result: they grossly overestimated their ability to get stakeholders to switch their processes. (Customers saying it is interesting, versus customers actually paying for and using it, is very different.) I want a founder who truly understands that companies don’t actually need what you are selling. Oftentimes, startups are building an entirely new market and have to create entirely new demand. Are you committed to doing that? This is why I mentioned in the first part of this series that I want folks who are obsessed. I believe obsessed individuals can often shape the world to their will.
The Human Condition Factor
This isn't only about assessing the founder/market fit in terms of sector. I am also looking at the emotional acuity of founders; do they understand the human condition aspect?
There are many things that people should want but don't. For instance, in manufacturing, I see a lot of startups building companies focused on preventive maintenance. It makes sense that when systems fail, a lot of money is lost. But, I have yet to see the market they are selling into have a strong willingness to pay for this. It just isn't urgent enough ahead of the disaster. Even though they claim to want it, it never seems to convert. And this to me, is a perfect example of the human condition. It’s similar to diabetes and obesity.
Many people know they are pre-diabetic, the doctors tell them, their friends tell them - everyone tells them. However, they still refuse to invest in preventing it. They won’t change eating habits, they won’t go to the gym, they won’t even work to get any extra steps in! They wait until things really break down and it is an emergency before taking action. AND, even then, as they are literally dying from it, many still won’t take action.
So I’m always asking what specific ability or insight a founder has that makes them believe they can shift these behaviors? But sadly, like the company that blew $30 million with nothing to show for it, I’m often met with 'just take my word for it.' That doesn't get me over the line. And for the founder, I’m bummed they’re forfeiting many years of their own life to it.
Is It Venture Scale? (The $100M Revenue Question)
I know many folks look at this question differently, but this is how I initially gauge whether a company is venture-scale: The baseline for me is what I call the $100 million revenue question.
In layman's terms, do I see a clear path to $100 million in annual revenue that is either recurring or sticky? Let’s say I love the founder, I think they are super sharp and totally the right person for the job. Now I’m gauging the scale of the opportunity and the type of revenue it pulls in — assuming everything goes to plan.
Recurring means they do monthly or yearly contracts, and the odds of the customers renewing are strong.
Sticky means it could be something where they do project-based, single one-offs, but there's regular usage. A good example could be permit submission, plan review, and approval for architecture firms. A large company may submit approvals frequently, resulting in high stickiness and predictable repeatability in this process. Or a port software, where customers may come and go regularly and predictably. Rather than an annual subscription, it's per use, but you’re able to predict future and repeated usage with high confidence.
The Math Behind $100M
The reason I use $100 million: Traditionally speaking, $100 million revenue times 10 multiple equals a $1 billion valuation. A billion-dollar outcome is what I consider a fund returner — meaning one investment can return my entire fund based on my portfolio model. (However, this is not a hard and fast rule, and I will discuss more deeply in part 4 of this series how entry price and outcome size play into this.)
Now, like everything else, there's nuance in how I’m thinking through the market on this. Example: If the only way you get to $100M is by capturing 100% of the market you're building in, that's a red flag. I’m not willing to bet you can get 100% — nor do I think anyone could. Alternatively, if you only need 5% of the market, but there are 300 other companies also trying to build in it, that could also be a red flag. These are just a few ways I am thinking through it. But the core question I’m asking myself is always the same: Do I see a clear path to $100M if everything works as you predict?
Now, it doesn't need to be a proven market. I’m fine with you providing a vision for a new market. But, I do need to envision a market large enough to support a company that can do $100M in revenue, even without you capturing 100% of it. This means the market needs to be BIG.
At Rock Yard, we have established core philosophies that define what we stand for. We write them on top of all our internal documents. Number two defines our ‘sole purpose and reason for existence,’ which comes down to searching for and investing in what we refer to as 'signature deals.' To expand on that in simple terms, these are companies that in ten years' time will be household names. NVIDIA, Autodesk, Adobe, SpaceX, Broadcom, ServiceNow, etc. These are the types of companies we aspire to invest in. That is the scale and magnitude we are looking for — and the founders who have a vision that big.
What that means is, in the best case, what you’re building is immensely venture-scale. If it works, there isn’t just a path to $100 million in sticky revenue — there is a path to a billion, or ten billion, or more, of revenue. That's the dream. So if I see something and think, "Hey, this is really good, but I could only see it getting to $20M, $50M, $75M a year, but not $100M" - there's a very strong chance it's a pass.
Tech Multiple vs Old-Line Business
Before we move on to the next part, I want to add one more thing about how I am thinking through underwriting and revenue multiples. I was first taught this by the inimitable Rich Wong at Accel, and over time, it has become increasingly fundamental in how I see the world.
In an acquisition, does the company most likely to buy you trade at a tech multiple or an old-line business multiple?
This is more important than many might realize, because any potential acquirer will likely value the acquisition in the same way the public market values them. More simply, if the company most likely to acquire you is Lowe’s Home Improvement, rather than Autodesk, the potential size of your acquisition price will be much lower just in terms of upside multiple.
This is immensely relevant in industrial-focused companies where a potential acquisition could be valued like a shipping company rather than a tech company. So, as we are assessing things, we’re always trying to fully understand who or what is being disrupted, and who or why someone might be incentivized to buy you. It’s not always straightforward.
A great example of this is the recent acquisition of Wiz by Google. Wiz clearly did not compete directly with Google, so it's not disrupting them; however, it’s also obvious that the service Wiz provides is something Google can benefit from. Google absolutely needs security. This is a great fit, and Google definitely benefits from acquiring them. In our case, we‘re looking for non-obvious companies like this in our spaces. An example is that we often look at manufacturing and CAD-related software with the thesis that robotics is one of the biggest growth opportunities of our lifetime. But robotics is much bigger than just the manufacturing and design portion. Potential acquirers far exceed those in the CAD space today. It could be anyone from Nvidia to Tesla, to Microsoft — folks who may have an operating system but need more hardware functionality, for instance. This is how we think about crossover opportunities, and we’re always looking at it with that lens.
We seek founders and opportunities that can significantly exceed their market.
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Next week in Part 3, I'll dive into team-building capabilities and the critical difference between sales-led and product-led founders.