Customer-driven entrepreneurship.
Gil Dibner

Towards the end of last year, I shared some initial responses to Sam Lessin’s thoughtful deck in which he describes the “factory system of venture capital” and how it may no longer be suitable for a great deal of companies, founders, and — even — venture capitalists.

During the last weeks of December and the first weeks of January, these themes have continued to echo, and I want to share my current thinking on the critical question facing so many early-stage founders: how does the art of entrepreneurship need to change in the face of the economic, technical, and financial dislocations we are experiencing now?

Build for customer revenue, not venture investment. To be fair, this was always the mantra. It was always easy to say one was building “for customers.” When was that ever not the right answer? But the truth is that in many cases, we were building something so that we could demonstrate customer love for VCs, to get the VCs to finance our next round. This tended to lead founders to emphasize things like Github stars, community engagement, advisors and angels, free PoCs, all sorts of very inefficient sales strategies in order to achieve some imaginary customer traction in order to convince VCs to fund the next round. At some point, mere demonstrations of customer love can become confused for genuine customer love. The key differentiator is revenue. Revenue is the ultimate measure of the value your customers see in your product, and your margin is the ultimate measure of how efficiently you can create that value. Down with PoCs, long live PoVs.

Remember the essential nature of software is profitable efficient growth. Business models matter, and the essential nature of software (especially enterprise software) is that it really should be the best business model in the world. A software business should be able to efficiently and rapidly create a ton of value for customers at high margins, spreading the vast majority of its cost base (engineers) across all its customers, driving up net margins with each sale. Of course, it takes time (and, often, venture dollars) to get to this point, but unless you can visualize this taking place, you may not have a viable business. Many of the companies with any revenue at all in our portfolio do seem to have a viable path to “default alive” status. We are working with them all to help them find the pathway to building a business that is both sustainable and highly scalable. Whether a company has raised $2M or $25M, if it is building truly valuable software there ought to be a viable pathway to breakeven or something close to it. If what you are doing is sufficiently valuable and unique, your customers will begin to fund your growth at some point.

The profit imperative holds diagnostic power. Much like a well-designed aircraft wants to leap into the sky, a well-designed software business wants to be profitable. When this is not happening, it’s critical to search for the underlying causes. Some are fixable, some less so. Here are three examples of good reasons. First, many companies are simply not charging enough for their product: they are creating but not capturing value. Second, many companies require more engineering work than they can afford: the product is not yet in a position for which the proper price (or any price) can be charged. Third, the team may lack sufficient sales skills (as many technical teams do). These three problems have relatively obvious fixes (raise prices; raise capital; hire or learn how to sell). Because these are good classic problems, it can be tempting to assume they are the case. Sometimes they are.

But there are more nefarious potential underlying causes as well: an insufficiently differentiated product; a product that does not create enough tangible ROI; a product with too painful a sales process or integration pathway; a product that targets a market that is far too small. Ultimately, many of these problems boil down to a problematic ratio between value created for customers and the ease with which those customers can be identified, engaged, and closed. The struggle towards profitability (or at least towards imagining a viable pathway to profitability) can be deeply revealing for a founding team that is willing to be sufficiently introspective. My advice is to run the mental exercise: can you build a profitable business assuming no further funding is available? If yes, you are almost certainly fundable. If not, why not? Can those deficiencies be addressed with a reasonable amount of investment? If yes, you should be able to convince an investor. If not, it might be time to close up shop.

The optimism of customer-driven entrepreneurship. I am aware that this may read negatively but that would miss the point. This renewed focus on the fundamental economics of the businesses we have backed as well as the new businesses we are planning to back reflects a return to the fundamentals of both entrepreneurship and venture capital. It’s profoundly optimistic. My faith is that when a founding team is sufficiently ambitious and innovative, they can create a pathway to real growth and sustainability with very little capital relative to the amount of value they are creating for customers. We see this in our portfolio over and over again. As Sam writes, the previous “factory approach” of venture capital — let’s call it capital-driven entrepreneurship — seems to have run its course. In today’s market conditions this approach — let’s call it customer-driven entrepreneurship — is the key to unlocking value and future venture dollars to grow even faster. There will always be hot areas (and we will invest in them), and there will always be founders who are great at raising money (and we will invest in them too). But we will also invest in founders that are steadily and doggedly building customer value, demonstrating that from one quarter to the next, and charting a path towards breakeven. Sometimes they will need a bit of extra venture dollars to get there, sometimes they won’t — but get there they will — and when they do it’s a whole new world for that business — and the sky is truly the limit.

What’s the unlock? As a final note, this whole thing can be understood in terms of the unlock: what’s the next unlock a founder is building towards? In the capital-driven approach, the unlock was always the next round. Founders would orient their business activities towards ensuring that the next round would happen, ideally at the highest price and the greatest amount of capital. This basically caused founders to outsource their strategy to unknown VCs in the hopes of closing the next round. It was based on the assumption that raising is winning and, thus, raising more is winning more. We’ve now seen how well this is working out.

Reframing the unlock. In the customer-driven approach, I submit that the critical unluck must be reframed as a new question: can this be a business? The point is not to always get to breakeven or always assume no capital is ever available. The point is to develop the conviction that the company you are building can be an actual profitable business at some predictable point in the future. If that is true, your company will survive: either because you will plot a course to profitability or because someone will be willing to fund you with enough capital to get there. In the market we are in now (and I don’t think this will change for a while), those companies are going to be the majority of the companies that thrive, that raise capital, and that achieve any real exit. My prediction is that the net batch of exited unicorn companies — real massive DPI for VCs — will come from companies that could have been profitable. My conviction is that real horses with real wings can fly higher and faster than any paper unicorn — and they will raise as much capital as they need.

Let’s go build them.

FROM THE BLOG

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Small & Strong Beats Big & Weak
Three startup paradigms in the LLM era.

The End of Entrepreneurship by Autopilot
The unicorn factory has stopped. What are the implications for founders?

No Words
The heartbreaking situation in Israel.

EUROPE AND ISRAEL FUNDING NEWS

UK / Enterprise. Vertice raised $25M for its AI-powered software spend management platform.

Israel / IoT. Xyte raised $20M (plus $10M in venture debt) to scale its device management platform globally.

Israel / Security. Secret Double Octopus raised $15M to further grow its enterprise-focused passwordless security platform.

UK / SaaS. Recraft raised $12M to build and begin scaling its generative AI-powered platform targeting professional designers.

Netherlands / Quantum. QphoX raised $8.7M to bring its quantum modem technology (hardware that enables quantum computers to communicate via an optical network device) to market.

WORTH READING

ENTERPRISE/TECH NEWS

340,000. That’s how many H100 GPUs Meta will have by the end of the year, according to Mark Zuckerberg in this interview with The Verge last week. He also explained why Meta will be tripling down on open-source AI with the upcoming release of Llama-3 and the merging of FAIR (the Fundamental AI Research lab, which has been a beacon of open source AI research over the past 18 months) with Meta’s broader generative AI efforts.

AlphaGeometry. A breakthrough from Google Deepmind: “an AI system that solves complex geometry problems at a level approaching a human Olympiad gold-medalist — a breakthrough in AI performance. In a benchmarking test of 30 Olympiad geometry problems, AlphaGeometry solved 25 within the standard Olympiad time limit. For comparison, the previous state-of-the-art system solved 10 of these geometry problems, and the average human gold medalist solved 25.9 problems.” Check out the paper in Nature here.

Powerpoint monkeys rejoice. Ethan Mollick shared a demo of Microsoft’s Office copilot in action this past week. He prompted the Office copilot to “write a Harvard Business School case about Tesla” and then asked the Office copilot to create a PowerPoint deck based on that memo. It’s not great, but it’s not half bad for about 1 minute of work! Consulting analysts everywhere…rejoice.

AI entering higher ed. ASU announces a partnership with OpenAI. Is this the beginning of enterprise-grade AI making inroads into higher ed? As part of the partnership, ASU will build personalized AI tutors for certain courses, especially STEM subjects.

HOW TO STARTUP

The cost of hype. Benn Stancil reflects on the cost of building in a hype cycle, the fall of the modern data stack and the rise of AI, and what it will take for next-gen data tooling companies to endure.

The IPO bar. A useful writeup from Jamin Ball on the bar for software companies to go public. Looking at data from companies that went public between 2015 and 2020, the median company had $200M ARR, 50% YoY growth and 120% net retention. That’s impressive! But the bar may be even higher than that. The reason why is because of opportunity costs. To invest in your company, public market investors need to sell their shares in other newly public companies that are growing 30%+ and look pretty good (Datadog, Zscaler etc.), or not invest in the Big 7 that are driving most of the growth in public equities right now. In other words, the IPO market may be open, but the bar has never been higher.

M&A is N/A. The EU blocks Amazon’s acquisition of iRobot, prompting many to wonder aloud whether acquisitions are legal in Europe anymore.

HOW TO VENTURE

Easy money. A fantastic overview from Howard Marks of the myriad impacts of the zero interest rate environment and what the long term impact is on how investors think about the world and make decisions.

ZIRPicorns, Papercorns and SuperUnicorns. Deep analysis and insight from Aileen Lee at Cowboy Ventures on the current crop of companies valued at $1B+. A few crazy stats for us all to digest: (1) the number of unicorns grew 14x — from 39 to 532 — in the past decade, but (2) 93% of current unicorns are still private. How much of that is real? Hard to say. But 40% of those 532 unicorns are trading below $1B in secondary markets. For more, see here.

The final Foundry fund. A thoughtful writeup from one of the most thoughtful teams in venture.

MANG. Must read from Apoorv Agarwahl on the impact of MANG (Microsoft, Amazon, Nvidia, Google) investing in AI companies via cloud credits on the private markets. Bill Gurley’s thoughts here.

PORTFOLIO NEWS

Aquant’s CEO, Shahar Chen, covers increasing accuracy and efficiency with AI copilots.

Reco’s Co-Founder, Gal Nakash, shared a step-by-step guide to the Golden SAML attack.

Snyk acquired cyber startup Helios for several tens of millions of dollars to boost cloud-to-code risk visibility.

JFrog unveiled a new integration with Amazon SageMaker.