Chris Dixon

An extremely useful concept that has grown popular among startup founders is what eminent entrepreneur and investor Marc Andreessen calls “product/market fit”, which he defines as “being in a good market with a product that can satisfy that market”. Andreessen argues persuasively that product/market fit is “the only thing that matters for a new startup” and that ”the life of any startup can be divided into two parts: before product/market fit and after product/market fit.”

But it takes time to reach product/market fit. Founders have to choose a market long before they have any idea whether they will reach product/market fit. In my opinion, the best predictor of whether a startup will achieve product/market fit is whether there is what David Lee calls “founder/market fit”. Founder/market fit means the founders have a deep understanding of the market they are entering, and are people who “personify their product, business and ultimately their company.”

A few points about founder/market fit:

Founder/market fit can be developed through experience: No one is born with knowledge of the education market, online advertising, or clean energy technologies. You can learn about these markets by building test projects, working at relevant companies, or simply doing extensive research. I have a friend who decided to work in the magazine industry. He discovered some massive inefficiencies and built a very successful technology company that addressed them. My Founder Collective partners Eric Paley and Micah Rosenbloom spent many months/years becoming experts in the dental industry in order to create a breakthrough dental technology company.

Founder/market fit is frequently overestimated: One way to have a deep understanding of your market is to develop product ideas that solve problems you personally have. This is why Paul Graham says that “the best way to come up with startup ideas is to ask yourself the question: what do you wish someone would make for you?”  This is generally an excellent heuristic, but can also lead you astray. It is easy to think that because you like food you can create a better restaurant. It is an entirely different matter to rent and build a space, market your restaurant, manage inventory, inspire your staff, and do all the other difficult things it takes to create a successful restaurant. Similarly, just because you can imagine a website you’d like to use, doesn’t mean you have founder/market fit with the consumer internet market.

Founders need to be brutally honest with themselves. Good entrepreneurs are willing to make long lists of things at which they are have no ability. I have never built a sales team. I don’t manage people well. I have no particular knowledge of what college students today want to do on the internet. I could go on and on about my deficiencies. But hopefully being aware of these things helps me focus on areas where I can make a real contribution and also allows me to recruit people that complement those deficiencies.

Most importantly, founders should realize that a startup is an endeavor that generally lasts many years. You should fit your market not only because you understand it, but because you love it — and will continue to love it as your product and market change over time.

The rational way to invest in something – a startup, public company, venture capital firm, real estate project, etc. – is to base your decision on an assessment of its fundamental value. The most common way to do this is to try to predict the asset’s future profits. In reality, many of the largest pools of capital in the world – pensions, endowments, and mutual funds – think in terms of “allocations.” This means they start with a model for how to distribute their funds across a set of dimensions, including asset classes, industries, and geographies. This allocation mentality is based partly on prevalent academic theories (the “Capital Asset Pricing Model” or “CAPM”) and partly on the success of certain famous money managers (the “Yale Model“).

Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).

Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”

We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.

Lodsys filed a complaint last week against a number of online retailers.  Lodsys is a so-called “non-practicing entity” – a patent holding company that doesn’t build products.  They previously filed lawsuits against Apple developers among others.  I am not a lawyer but I wanted to try to understand the case so read some of the documents.  This is my best understanding of the situation.

Here is an example of Lodsys’ accusations, in this case against bestbuy.com:

The reference to ’908 is referring to patent 5,999,908, which was filed in 1997.  It is an invention that appears to allow users to give feedback to websites:

Here is one example diagram from the patent about how the invention could be embodied:

Here is the specific claim (claim 37) that bestbuy.com and other retailers are allegedly infringing:

As far as I can tell, the first clause says that it the claim is referring to a computer product, which in the case of bestbuy.com seems to be their website, where the user and server can send information back and forth.  The second clause seems to say that this system includes computer code. The third clause seems to say this system includes a database.  The fourth clause seems to say there is a information transmitted between the user, web server and database.

Last night I taught a class via Skillshare (disclosure: Founder Collective is an investor) about how to raise a seed round.  After a long day I wasn’t particularly looking forward to it, but it turned out to be a lot of fun and I stayed well past the scheduled end time.  I think it worked well because the audience was full of people actually starting companies, and they came well prepared (they were all avid readers of tech blogs and had seemed to have done a lot of research).

I sketched some notes for the class which I’m posting below. I’ve written ad nauseum on this blog (see contents page) about venture financing so hadn’t planned to blog more on the topic.  But since I wrote up these notes already, here they are.

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1. Best thing is to either never need to raise money or to raise money after you have a product, users, or customers.  Also helps a lot if you’ve started a successful business before or came from a senior position at a successful company.

2. Assuming that’s not the case, it is very difficult to raise money, even when people (e.g. press) are saying it’s easy and “everyone is getting funded.”

3. Fundraising is an extremely momentum-based process.  Hardest part is getting “anchor” investors.  These are people or institutions who commit significant capital (>$100K) and are respected in the tech community or in the specific industry you are going after (e.g. successful fashion people investing in a fashion-related startup).

4. Investors like to wait (“flip another card over”) while you want to hurry. Lots of investors like to wait until other investors they respect commit. Hence a sort of Catch-22. As Paul Graham says:

By far the biggest influence on investors’ opinions of a startup is the opinion of other investors. There are very, very few who simply decide for themselves. Any startup founder can tell you the most common question they hear from investors is not about the founders or the product, but “who else is investing?”

5. Network like crazy:

• Make sure you have good Google results (this is your first impression in tech). Have a good bio page (on your blog, linkedin and about.me) and blog/tweet to get Google juice.
• Get involved in your local tech community.  Join meetups. Help organize events.  Become a hub in the local tech social graph.
• Meet every entrepreneur and investor you can.  Entrepreneurs tend to be more accessible & sympathetic and can often make warm intros to investors.
• Avoid anyone who asks you to pay for intros (even indirectly like committing to a law firm in exchange for intros).
• Don’t be afraid to (politely) overreach and get rejected.

6. Get smart on the industry:

• Read TechCrunch, Business Insider, GigaOm, Techmeme, HackerNews, Fred Wilson’s blog, Mark Suster’s blog, etc (and go back and read the archives).  Follow investor/startup people on Twitter (Sulia has some good lists to get you started here and here).
• Research every investor and entrepreneur extensively before you meet them. Entrepreneurs love it when you’ve used their product and give them constructive feedback.  It’s like bringing a new parent a kid’s toy. Investors like it when you are smart about their portfolio and interests.

6. How much to raise?  Enough to hit an accretive milestone plus some buffer. (more)

7. What terms should you look for?  Here are ideal terms.  You need to understand all these terms and also the difference between convertible notes and equity.  More generally, it’s a good idea to spend a few days getting smart about startup-related law – this is a good book to start with.

8. Types of capital:  strategic angels (industry experts), non-strategic angels (not industry experts, not tech investors), tech angels, seed funds, VCs.

• VCs can be less valuation sensitive and have deep pockets but are sometimes buying options so come with some risks (more).
• Industry experts can be really nice complements to tech investors (especially in b2b companies).  (more)
• Non-strategic angels (rich people with no relevant expertise) might not help as much but might be more patient and ok with “lifestyle businesses.”
• Tech angels and seed funds tend to be most valuation sensitive but can sometimes make up for it by helping in later financing rounds.

9. Pitching:

• Have a short slide deck, not a business plan. (more)
• Pitch yourself first, idea second. (more)
• Pitch the upside, not the mean (more)
• Size markets using narratives, not numbers (more)

10.  Cofounders: they are good if for no other reason than moral support. Find ones that complement you. Decide on responsibilities, equity split etc early and document it.  (Legal documents don’t hurt friendships – they preserve them).

11. Incubators like YC and Techstars can be great.  99% of the people I know who participated in them say it was worth it.

12. To investors, the sexiest word in the English language is “oversubscribed.”  Sometimes it makes tactical sense to start out raising a smaller round than you actually want end up with.