This column originally ran in Forbes.
Last month, I was privileged to be on a virtual panel led by Shruti Gandhi of Array Ventures when she asked a thought-provoking question: Is there a metric for deciding when to fund a Series A round?
Everyone on the panel quickly agreed there is no simple metric. But in the weeks since, I’ve further reflected on the question and believe that there is a misunderstanding about the criteria for raising a Series A financing. Entrepreneurs are sometimes unclear about whether they are “too early” to have a conversation with us at Greylock or other leading VCs, just because they are at a concept stage or don’t have customers or revenue.
Yet early financial metrics are not a reliable signal for the ability to build a large or valuable company. I have sat through many presentations by founders who shared initial evidence of revenue or customer interest. But over the close to two decades I have spent as an early-stage investor, I’ve discovered that there are three questions that invariably lead me to greater clarity about whether I should invest:
- Is the founder mission-driven?
- Can the idea become a superior product with large demand?
- Can the company grow into attractive metrics at scale?
Let me expand on each of these questions by drawing on past experience.
The Mission-Driven Entrepreneur.
A mission-driven entrepreneur is someone who wants to solve a real customer problem and then pursues it with extreme focus, grit, and a learning mindset. “Mission-driven” also requires delivering results in the near-term, while not compromising long-term thinking and vision. Success requires building a culture of excellence, having self-awareness and attracting highly talented people.
In 2005, Palo Alto Networks’ founder Nir Zuk set out on a mission: disrupt the network security status quo and re-invent the firewall. Nir was methodical about picking a large market. Initially few customers were willing to listen to yet another vendor in an already crowded space. He persisted and eventually talked with 40+ customers while still formulating the concept. Although trained in mathematics, he wrote a detailed marketing data sheet with features/benefits for the 1.0 product to convince himself that someone would have interest. Most founders don’t have this level of intellectual rigor or grit.
Greylock teamed up with Sequoia to seed Nir with $250,000, and subsequently the company’s Series A funding.
We had great confidence in Nir’s ability to analyze the market. Equally important, however, was that Nir already had won the confidence of an array of engineers at Juniper, Cisco, McAfee and elsewhere. The moment he began building a team, there was a line of high-caliber people who wanted to follow him – an indispensable quality that one always looks for. In 2012, Palo Alto Networks (NYSE: PANW) went public.
Superior Product, Large Demand.
A superior product solves a real customer problem and use cases with a differentiated approach. Additionally, VCs are always on the lookout for a product that not only creates immediate demand, but also offers the potential of upside over multiple years as a true platform.
In almost every initial meeting with an entrepreneur or founding team, I ask: “why now?” Contrary to conventional wisdom, timing is usually not a product of good luck, but rather a function of trying to understand when a market is ready for something different. An emerging market that has clear potential to grow is always attractive to investors who see first-mover advantage. Yet it is also true that the large, proven market that might appear to be filled with incumbents may actually be ideal for a new company to insert itself artfully and seize market share.
In 2009, I was fortunate to meet with Christian Beedgen, chief architect at ArcSight. When we met, “on-premise” log management and analytics were the industry standard. Together, we began to sketch out what the implications might be if that market were to shift to the cloud. We estimated that the current market was at least $2.5 billion, yet the existing on-premise products had high total ownership costs and were not built to scale. There was a quick realization that a cloud-based solution delivered at massive scale could be a better path forward.
We subsequently led a Series A financing along with Shlomo Kramer. At the time, the company had only a few slides and had zero code, zero revenue, no customers, and was still without a name. Those facts were immaterial to our decision. This was a case where the primary considerations were the prevailing market dynamics and the fact that we could see a superior product developing that would solve customer problems with differentiated architecture. Equally important, we could imagine a platform company that would address multiple use cases. Last year, a decade after our initial meeting with Christian, Sumo Logic (Nasdaq: SUMO) launched their IPO as the leader in continuous intelligence with more than 2,000 customers.
Attractive Metrics at Scale.
Early-stage companies are typically funded at concept, pre-revenue, or initial revenue stages. Often they do not even have any financial metrics or projections and when they do, they are of limited value. The more important question is what might be achievable at scale, specifically: top-line growth, gross margin, sales efficiency, net dollar retention, and operating leverage.
I recently met with an ambitious entrepreneur whose new company had a solid roster of customers. Their billings during the first few quarters were impressive. But I passed on the investment because, while I admired the individuals and liked their idea, I couldn’t envision a path beyond $20 million in revenue.
The truth is that many successful venture capital-backed companies start slow, not fast. The real question for investors is whether there can be a roadmap and sustained path to grow a product’s value with scalable pricing. A VC makes a judgement call on whether the future company can have strong margins, matched with an efficient go-to-market model. In effect, the investor wonders: What can this company become? Is the product best sold via a traditional enterprise sales motion or bottom up sales? Can the product lend itself to extensions? Will customers renew subscriptions and expand? Great engineers may know how to develop pioneering products, but they rarely come to an initial meeting with answers to these questions. Nor should they.
Avi Networks had three technical founders who had worked together at Cisco over many years. In 2012, they pitched me on a Sunday morning with a plan to reinvent the existing multi-billion dollar load balancing appliance market through a new software-based approach.
Despite the fact that the company had no code developed and no financial metrics, we nevertheless committed to a large Series A financing in partnership with Lightspeed a few days after the initial meeting. Our decision was based on backing an exceptional technical team combined with a view of what the nascent company could look like at scale. We knew the industry segment well, and knew that F5 and Citrix were the leading incumbents. Our enthusiasm was premised on the idea that if customers were already willing to pay for the incumbents’ hardware-software combinations, they would be open to subscribing to a software-only solution in a subscription model. That meant high margins and the ability to multiply accounts with high net dollar retention. The market was not only established, but open to disruption, and easily extended.
Avi developed and brought their software approach to market, and established a beachhead with enterprise customers, with attractive “land-and-expand” dynamics. In 2019, the company was acquired by VMware (NYSE:VMW).
These anecdotes are a reminder that the “metric” for what wins Series A funding isn’t a pat formula. So much depends on the mindset of the founder, the right combination of product and market, and whether the business can achieve attractive metrics at scale. Entrepreneurs that come to the table with the right mix of these elements will find an investor who wants both to write a check and be a strong partner for the road ahead.