82. Getting Smart on a New Market, Part 2 (Charles Hudson)

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Today we cover Part 2 of Getting Smart on a New Market with Charles Hudson of Precursor Ventures. In this segment we address:

  • New Market thesis part 2 Charles HudsonHow do you look at companies addressing industries where the incumbent product offerings are free.  Businesses like Slack that were replacing free options
  • Fresh Eyes… You’ve written about how you don’t look at decks before the first meeting w/ an entrepreneur. Can you touch on the key reasons why you take meetings without reviewing the deck?
  • If you are evaluating a startup that is pre-traction – what do you look for and why?
  • In the spirit of continuous improvement… What are your thoughts on how one can learn and improve once they have a job in VC?
  • What startup investor has inspired and influenced you most and why?

Guest Links:

Key Takeaways:


1- Market Structure Over Market Size:

The three things that Charles looks at w/ a new market is:1) Market Structure
2) High-level economics of the business at scale and
3) Relevance and the timing of the opportunity… what Charles summed up as “is the world bending in the direction that these founders want to go?”First, Charles attempt to pick apart a market and look for all the factors that make for a good market vs. a bad one. He asks the question “what is this market going to look like at scale?”-Is this a winner-take-all market at scale? Where the steady-state is that the market leader will get a disproportionate share of the outcome.
-Are there network effects?
-Are there structural reasons why everybody (consumers and service providers) should be on one platform
-With a majority critical mass of users are there tremendous benefits to the greater network of users?
-As more users are acquired, do the benefits increase for all users on the platform?When all are on one platform, the benefits can include things like:
-more liquidity
-the lowest search costs and the
-lowest transaction costs for both sidesHe did mention that there are cases where the constituents in a market would not like one monopolistic provider. But there are some markets where the steady-state is going to have one large winner.

2- Fragmented vs Consolidated Markets

Charles went on to describe markets that are really fragmented. He brought up the example of SalesForce and how many assume that they own the majority of the market when, in fact, they have about 20% share of the CRM market. In these cases it can be really hard to build a standardized product that can serve the needs of all customers. This was where we talked about the degree of homogeneity of customers. If customer needs are very heterogeneous, it is going to be very difficult to develop a solution that serves all and also to sell that solution in a scalable way.

His final point here is that he doesn’t like competing with large, majority share incumbents in their home markets. He wouldn’t want to compete w/ Google in search or back in the 90’s w/ Microsoft in productivity apps. If you compete with the biggest in their core market, you will get their best punch and their best people are working to defend the core. In these cases a startup must have a differentiated approach toward go-to-market, relative to the incumbent.


3- Nascent Market TAM

Charles starts w/ the question: “Are people already spending money against this problem today?” Then he looks to see how current spending habits map to new spending habits w/ the startup’s offering. And one of the watch-outs here are companies looking to radically reduce costs. If they’re playing in a billion dollar market and they plan to reduce costs by a factor of 10, then the market will shrink to 100 million.

Then he looks to see if the leading companies are healthy, good gross margin businesses. There are plenty of verticals with massive TAMs but razor-thin margins, like retail grocery.

And he also think about whether a whole new group of users will be brought into a market. Is the question one of non-consumption? If so, the TAM may not be that relevant. Or does the startup plan to reallocate surplus from one level in the value chain to another. In that case, the current TAM will be much different than the eventual market size.

And his final point here is that he’s not using TAM to calculate an exact market amount or revenue amount that will be achieved in the coming years. Rather, at a macro level, does he see a large number of customers that will be willing to pay a high price. It’s really just that simple.



Tip of the Week:   The Customer Volume Value Curve


*Please excuse any errors in the below transcript

Nick: You mentioned earlier that you prioritize market structure over TAM. And TAM is typically a function of price and volume. If the product is this fuzzy thing that’s maybe less important than the team and the market, you know, how do you assess the, the TAM? Specially in a nascent market that doesn’t yet exist?

Charles: Yeah. That’s so hard, # Nick. I don’t, I wish I could tell you like I have a really grand theory. I mean, but I guess I start with, I start with one of the big questions like are people already spending money against this problem today? And if some problems are the answer is yes, and then I always ask myself and to the extent that the answer is yes, how does the way and amount of money that people are spending against this today, map to what the company plans to do? Because there’s some companies where, you know, their plan is to radically reduce cost by a factor of 10. And they’ll show me hey it’s a billion dollar market there. I’m like okay so you’re trying to take it to a hundred million then. And I think sometimes founders don’t always connect the dots between the reason that TAM is high is because the competitors solution is more expensive and that you replacing them will actually shrink the TAM

Nick: Yeah

Charles: But I also look at not just like is it a money being spent, but are the leading companies healthy good gross margin businesses? So like the TAM for grocery stores is enormous. The gross margins for running a grocery store, unless it’s whole foods, are like not amazing.

Nick: Interesting

Charles: And so versus the TAM, I mean look, #Workday, #Salesforce, Markadle, #Oracle, we’re talking about 70% gross margin businesses. Pretty good businesses to be in at scale, and big TAMs. So I’m always trying to ask myself like if this company is successful, what does the world look like when they’re successful? Is it a lot more, are they going to fundamentally bring a bunch of new consumers to the market? And like this is about non-consumption until the current TAM isn’t that relevant because their whole belief is that they’re going to bring in some new people who have been on the sidelines of the market? Or is it that they’re going to reallocate sort of some of the gross margin that’s kept by this the surplus that’s kept by the producer and reallocated to the consumer? Because I think all of those things if you kind of pull on those threads long enough you eventually get to an answer.

Nick: Right, right

Charles: And my TAM answers are usually this feels like it’s going to be a really big market because I can envision a lot of people paying a reasonable price for this product in the future, not so much I think it’s going to be $250M in revenue in the next 5 or 7 years.

Nick: Right, right. Yeah, and I get that. And I love the example of looking at established healthy companies in the area and if they have attractive gross margin profiles. But what about like, what about a company like # Slack? You know, prior to #Slack, I know that when I worked in a corporate environment, we used yahoo instant messenger for direct messaging and we used email for all other communication. And both of those tools were free. So, so how do you look at that? You know a company that’s, that arguably is bringing significant value, but into a marketplace where the incumbents or the established technologies are free?

Charles: I think that’s super hard. It’s, I’ll say two things about that. One, I think one of the hardest things to do as an investor is to put aside previous experiences and approach a problem with fresh eyes. And I think if you’d said no to every other enterprise messaging company out there, except for #Slack, you probably are feeling pretty good about yourself. Because #Slack has been, and maybe I’d say you know # HipChat as part of # Atlassian has done really well. But for the most part like being skeptical on that space was right. But I think if you asked yourself like what would it take, like what would it probably take to get enterprises to pay for this? One, it would have to be a product that you could get into the hands of developers and consumers easily. So it has to have low cost distribution. The price per user has to be pretty cheap. And there has to be some compelling reason why you as a company would upgrade to a paid version. And I think for most companies it’s kind of security, audit, logging, like those things matter. And conveniently or diabolically for #Slack, however you want to think about it. The more people you have in your company using the product, the more value the security and enterprise features have for you. And so, I’m not entirely sure what it is about #Slack that made people so ready for the product. You could argue hey it was things like #Yammer in chat or before they had kind of gotten people used to the idea of this lightweight corporate communication. We could maybe go all the way back to Aim and those instant messaging products which you know by and large are not well supported anymore. And that maybe had those products continued to be supported or the companies behind those products continued to invest in them. But I think you could trace the behavior patterns all the way back to there. And maybe the time was just right. And a post Yammer, post Slack, post Facebook, post Twitter world

Nick: Right

Charles: people said hey this is the way I communicate in my personal life. Why not have it in a world where email just feels like completely oppressive. Maybe this was just the right time to have an enterprise communication product, particularly if you think about developers who were some of the early advocates. They tend to be people who in my experience like email the least. Business people like me tend to like email. And so it’s not surprising to me that a lot of my earlier doctor friends who got on, got on Slack were developers. And they were able to connect things like #Github and #Stripe that they care about into their Slack channels. But if you told me hey we’re going to build this communications platform for businesses, it’s going to integrate with a bunch of other services you use, and we’re going to charge companies based on usage, I would say that sounds like a perfectly reasonable idea that many people have tried before and have failed

Nick: Yeah

Charles: And so what is it about the context now that makes this the right time? And it’s so hard as an investor sometimes to put aside previous experience because you definitely don’t want to recreate the same mistake that you’ve done before. Because it’s really painful to think yeah you know, I kind of knew that that’s typically what happens with these kind of startups and I just kind of invested in another one. And I feel like it’s going to end exactly the same way. So clearly I didn’t learn anything.

Nick: Chasing

Charles: Yep

Nick: To your point earlier, why not 2 years ago, why not 2 years from now, context is everything

Charles: Yeah and it’s so, and it’s you know I will say like a lot of the investors I admire the most, they have this I don’t even know if they can put it in words. They just have this feeling or this, this accumulative set of experience that makes them particularly good at making assessments on timing. They just seem like to be very very good at, and I’d say you know the best of the best people I know, you get a combination of timing and they have enough access to gauge for real teams that they find the right team at the right time. And that’s just, I think that’s a really durable competitive advantage in venture. If you can get really good at doing that, you can stay in this business and be successful for a really long time.

Nick: So you made a point about looking at markets with fresh eyes. And you’ve written about, in the past, about how you don’t look at decks before the first meeting with an entrepreneur

Charles: Yeah

Nick: By the way, side note, I am completely addicted to your blog, you know

Charles: Oh thank you. I need to do more writing

Nick: You should! You got to get back on!

Charles: It’s coming. It’s coming. I’m building up a backlog of posts. So the, they are coming. Yeah, I don’t know the whole decks thing, it’s one of those things that sometimes you say things that just seem obvious to you and other people tend to bristle. I think in venture there’s this theory that, you know, you have to see the deck first because you know, what one person told me, the ability to put together a good deck is indicative of some familiarity with the fund raising process. And I think a lot of people use the presence or existence of a deck as a qualifier. Like hey if you can’t even put a deck together, why should I take a meeting? I think that’s totally fair. If your principle objective is to filter out people who you deem to be unserious from your calendar. Totally fair. What i learned is, I don’t know about you #Nick, like I’ve never been in a meeting with a vendor or I’ve never bumped into someone on the subway and they said hey before we have this conversation let me pull a deck and walk you through it, right? Like if you are at a dinner party and someone asks you hey what do you do? You don’t say hold on, before, let me, let me tell you, let me pull out this deck on my phone and slip you through it.

Nick: I haven’t done that one, no

Charles: Yeah, and so the reason I don’t get too obsessed about decks is, one, I just know myself. And if you send me a deck, I’m going to read it and I’m going to reach some conclusions based on the way that the information is presented. I’m going to come into the conversation kind of locked and loaded on a couple of things. And sometimes being so fixated on one or two topics that I saw on the deck, it blinds me from paying attention to what the founder is actually saying in the meeting. Because I’m just waiting to get to the customer acquisition slide, because that’s the one where I have bunch of questions because I read the deck before. So it inhibits listening. Two, I tend to judge the business without the benefit of the founder narrative. And not every deck tells you the whole story. And I find the good ones intentionally create gaps in the narrative because they don’t want to give the whole thing away. And third, and more importantly than that, to me the ability for someone to tell a stranger who’s unfamiliar with their product or service about it in a conversational way, without the aid of a visual crutch is actually something a good founder does a hundred times a week. You’re pitching candidates, you’re bumping into people at lunch. Like a good founder is always recruiting new investors, is always recruiting new employees. And most of those interactions are unplanned and casual. And I think the better, if you’re at a dinner with a candidate and you’re trying to close them and they’ve got a bunch of questions about the business again, you can’t pull out, you can’t rely on the deck as the things that will sell them. So I’m very interested in founders who I think are good story tellers, and who I think can weave together a narrative, and who I think can have a conversation around the business that doesn’t need a visual aid. Because a lot of life doesn’t give you that opportunity. The last thing is I’ve just found not requiring a deck, it allows me to meet with people who are not maybe as far along in flushing out every element of the business. And I’m okay with that. And candidly sometimes those meetings are really bad. And sometime I meet with someone and am like wow, you’re really not as far along and thinking this out, thinking this through as I thought you are. Had I sort of slightly raised the cost of you getting on my calendar I probably wouldn’t be in this meeting right now. To me that’s okay. It’s a question of like what scares you more- spending time in the occasional meeting that’s not productive or missing out on someone who’s maybe the chance to build a relationship with someone who’s not as far along because they don’t have all the materials that tick the boxes for you?

Nick: Sure

Charles: So when I say like I don’t need to see a deck, it’s like I’m willing to meet with people who are still wrestling with kind of the core things in their business

Nick: Yet you’re the first person I’ve met that doesn’t look at the deck, or at least publicly says they don’t look for a deck pre-meeting. But I don’t either. And it was based on something you said. I view is as either a crutch or a tool.

Charles: Yeah

Nick: And the first time that I meet someone, I want to hear it because

Charles: Yep

Nick: they’re going to have to sell their business to everybody, every stake holder. And they need to be able to do it without the crutch. And if you can get to the second meeting then I think the deck can serve as a good tool to, to transmit a lot of information about some relevant pieces, but without the sales, without that elevator pitch that really compels me to want to learn more. It’s just not worth it for me to to try and comb through a deck and try and understand what they’re getting at.

Charles: Yeah. What I usually tell people is I certainly don’t want to take a meeting where 10 minutes in I go hey we got to stop because I have a company that’s in conflict with what you’re doing, or I have looked at the space 50 times and like I have never gotten to a yes. I can usually accomplish that with just a brief paragraph, like hey can you just tell me what you’re doing. And like what you’re working on in like 5 or 6 sentences over email so that I can make sure that I’m not going to put us both in an awkward position by agreeing to a meeting where I quickly realize that jeez you know like I’ve got something in the portfolio that’s a little too close for comfort relative to what you’re building.

Nick: Yeah

Charles: And that’s for me like that the main knock up. But I also just think I have a higher tolerance for meetings that maybe don’t go anywhere than some of my peers. And I just feel like I would much rather meet interesting people earlier in their journey. And I’m willing to accept that some portion of the things I have in my calendar could have been filtered out with a more rigorous kind of get a meeting criteria, but the more rigorous the filter it influences how approachable you are. And my goal is to invest in people at the first stage. And the, the less experience they have at the fund raising process often times the more raw that first presentation of the business might be.

Nick: Yep. I love the focused concise emails from entrepreneurs with

Charles: Yeah

Nick: couple sentences on what they’re doing, and get me interested enough to ask for a deck.

Charles: Yeah. Right

Nick: So, so #Charles, I want to ask you a little bit about pre-traction startups

Charles: Yeah

Nick: So, you know, a startup comes to you, no traction, early stage. What do you look for and why?

Charles: Well, it’s so hard. So, one thing I always ask myself is like is there a good reason why this company doesn’t have any traction? For hardware companies, I think it’s easier because often times like the physical manifestation of the product  that just doesn’t exist. Like no one’s, there is no product to buy or use yet

Nick: Yeah

Charles: So that kind puts that to the side. But sometimes I’ll look at a business and say okay what’s the logical leap here? Like is this something that’s so abstract and hard to imagine that even if it existed today I’d still have the concerns about whether anybody would use it? Or is this the product category where I am pretty convinced that they’re some level of endemic demand for the product? And the real question is can this company capture it? So for software companies, this is something I’ve thought for a long time and I haven’t really shared with many people, I think most things in software can be built. Now maybe some of the weird deep learning, AI kind of things like maybe those can’t be built. But if you named a B2B enterprise software category and you told me what the product is, like I think most things in software can be built.

Nick: Sure

Charles: So really the real risk is it like can it be built? Everyone says hey can the team that’s been assembled before me, can they build it?

Nick: Execution

Charles: So that’s, that’s one. And do they have a proven track record of building stuff? I think number two, and this goes back to market structure, relative to where the industry is, what does meaningful traction look like? So I think if you’re again, if you’re building a brand new CRM company, you should have customers pretty quickly. Because it’s a known category with lots of buyers. And you should be able to pretty quickly get to the point where people are using and paying for the software that you’re building. Like that to me doesn’t seem like an inappropriate ask or expectation. However, if you’re in a brand new category, particularly for consumer facing social apps, often times you have no idea whether anybody will use it. And there is no good analog for the product. And so I think for me for hardware there is legitimate questions as to like whether the products can occasionally be built or manufactured at a cost and scale that will appeal to the consumers. That’s reasonable thing to ask of a hardware company. So that’s one. I think the second thing is always relative to where the company is, do I think that they have reasonable expectations for how much money they want to raise and the terms at which they want to raise it? And that’s kind of a squishy topic. And so sometimes I’ll meet people who go hey we want to raise 750K to finish our prototype, get it in the hands of our first 5 customers and we’re willing to do that at a valuation that reflects the fact that this is an unproven concept. And I think we’re at this weird moment in the venture capital market where almost everyone I know would much rather pay up for something that they know works than take a bet on something that hasn’t been built and doesn’t work. And so I think we’re in this really strange world where, at least in my opinion, people place a lot of weight on traction and perhaps even over value traction. And where people are so terrified of backing a company that doesn’t end up being the winner, that maybe they apply too great of a discount to pre-traction. For my model that’s great. If that’s the way that the world actually works.

Nick: Interesting. Just to transition a little bit, in the spirit of continuous improvement,

Charles: Yeah

Nick: What are your thoughts on how one can learn and improve as a venture capitalist, maybe from your standpoint and/or also from someone new to venture capital?

Charles: So, I’ll say that there’s I think the obvious things to do, you know, get mentors, surround yourself with people who’ve been doing this longer than you have and have been doing it well for longer than you have. And try to learn from them. I’m a big believer in taking notes. Because I think it’s very easy to engage in revisionist history and venture. And sometimes you’ll say like why did I pass on that company? And if you try to reconstruct it at the time that you know it was successful, it’s very easy to tell yourself a self serving narrative. But if you kind of take notes along the way when you see things, I think it’s a really good to get better and identify your own blind spots. So for example, one thing that I do is whenever I go to # Y Combinator demo day, every year I go I take copious notes on the companies that I saw and which ones I liked and my initial impressions of them, and granted these are not very long pitches. And every year when I go back, I look at the notes from the previous two years and I ask myself kind of the same two questions- which companies that I thought were amazing and interesting turned out to be amazing and interesting or turned to not be amazing and interesting. So how did the ones that I liked, how did that pool perform? And what are the ones that I missed and why? And for me it’s just a good mind state to go into like YC demo day where it’s like historically what I’ve realized for a long time a developer facing things were not companies and products that I particularly understood very well. And so I tend to not have strong opinions on those. And so I think the good news is if you are at, at an active venture capital firm, you’re going to meet hundreds or thousands of entrepreneurial teams over the course of the year. And you’re going to make a bunch of decisions on them and you’re going to form conclusions and if you’re good at documenting your own thought process and being reflective, you can go back and with the sample size of two or three thousand companies and interactions, you can recreate patterns.

Nick: Any other final thoughts on the topic today or other things related to, to investing in startups?

Charles: I’ll tell you one thing I was thinking about was just like well what are some of my like greatest misses or things that I regret sort of having not invested in, I really wish I had invested in every single person from my business school class who started a startup because there are some patterns that I think, I think even within rules there’s freedom and I think one area where I’ve been giving myself a bit more freedom in my new fund is there is a certain class or set of people that I have known for a really long time who I think they just have a knack for figuring it out. And I would never want to construct a portfolio that was a 100% composed of them. But to pass on them because they don’t have everything figured out. They have a track record of going from kind of murky fuzzy to fully formed in pretty rapid succession. And you know that includes like the founders of # Trulia and some other like really successful interesting internet tech and even non-tech companies. And I think occasionally you tap into wells of really talented people. And having a different bar or process for funding them is not necessarily the worst thing in the world.

Nick: Very cool. So # Charles, if we could address any topic related to startups or venture, what topic do you think should be addressed and who would you like to hear speak about it?

Charles: You know, I really think a great person to talk to would be # Bryce Roberts from # Indie VC, who used to be at # O’Reilly AlphaTech. And just talking about the alternative path to the raise a bunch of money high growth venture model. Because it doesn’t work for every single business. And more importantly, it doesn’t fit the cultural context of every founder. And I think he’s got a really interesting, you know, set of thesis and dots around that topic.

Nick: Awesome. And then, # Charles , what startup investor has inspired you and influenced you most and why?

Charles: There’s quite a few. If I could pick two, I’d probably say # Chris Dixon is high on my list just because he seems to have a really good sense of that intersection of timing and special teams and areas that seem wonky, weird, undeveloped or too hard, he seems to have a really good nose for picking those out. And making them, and getting the right teams at the right time to build the right companies. So I really admire him. The other person is kind of for really different reasons, it’s actually # Michael Dearing from # Harrison Metal, who I just think is super thoughtful about people and about the founders he backs and what are early means to support them. And I’ve just been really impressed by the depth of attachment and affinity the founders he’s backed have for him when it comes to two, three, four startups later. How they still kind of have a strong I think personal connection and warm feeling toward the time that they spent with him regardless of the outcome of that startup. And I think if you can cultivate that in the people that you back and support as a VC, that’s a, that’s a really big deal.

Nick: And finally, # Charles, what’s the best way for listeners to connect with you?

Charles: They can always hit me an email charles@precursorvc.com or I’m on Twitter most of the day too, and actually interact with a fair number of people I don’t know that way too. I will have a website up soon. It’s under development, it’s just not done yet

Nick: Awesome. Well, thanks again for making the time here. Like I said before, your blog has been very inspirational to me and I’ve been admiring from afar for some time. So really appreciate you doing this interview and look forward to more.

Charles: Thanks so much. It was a pleasure, #Nick, take care.