On Indexing the Early-Stage Market of Funding for Bootstrappers

Lately several people have asked me, is “Earnest Capital trying to index early-stage software companies?” The answer is “no, not really” but there is an interesting discussion to be had around the idea of indexing so it’s worth unpacking.

AngelList Data shows that “indexing” early-stage (pre-seed/seed) investing produces superior returns than picking deals.

One reason this is even an idea is that AngelList released a pretty interested white paper about the idea of “indexing” (buying a weighted average basket of all deals versus investing in individual deals). I did a thread reacting to the white paper here:

AngelList is a platform for angel investors and now funds to invest in startups and they have a pretty broad dataset of deals. Their data science team ran the numbers and found that if you had invested in a weighted average “index” where you are invested in every credible deal on the platform, you would almost always generate better returns than picking 10, 20, or 50 deals yourself.

The reason for this effect is the power law: in the AngelList dataset, a huge portion of the total returns to all investors comes from a tiny number of individual investments like Uber, Stripe, Airbnb. Of the 3,000 seed deals, if you missed out on any of these, your portfolio would underperform the index. The more extreme these individual outcomes become, the more the index will beat any individual picker.

Some important caveats:

  • They say this only holds true for early stage seed and pre-seed deals, at the later stages this effect goes away.
  • Every credible deal is an important distinction. Investing in literally every entrepreneur with an idea would obviously not produce superior returns given the number of bad ideas that never get off the ground. But how to measure “credible” is not at all obvious. A short-hand way to do it is “any deal with an actual VC fund leading the round.” Which to me seems like a better-than-nothing solution but not totally convincing.

Some thoughts on AngelList data

The returns to indexing, while technically better than not indexing, are still not very good and in my opinion don’t clear the hurdle of sufficient return relative to the risk. A reasonable conclusion might be: indexing is better than picking, both produce pretty bad returns, so the best advice is just don’t do angel/early-stage investing.

Returns *excluding* the >50% of investments that fail

These returns exclude all the losing investments that went to zero (at least half). So you can cut these by half to get a general sense of what the actual return to investors is: median of less than 1x your money back, mean of slightly above 1x your back. Not great.

Indexing doesn’t get you any of tangential value of angel investing, which for many people is most of the value:

  • Build relationships with smart founders
  • Learn a ton via company updates and pitching dealflow
  • Potentially get a huge out-sized win

Indexing across a theme

In my opinion the best way to adapt to these realities is to take the idea of indexing and apply it not to “all early-stage startups” but to a specific investing theme or trend that you (a) think is a strong bet and (b) you want to learn more about and plug into.

I think new funds like Andreas Klinger’s Remote First Capital (focused on remote work startups) or Ben Tossell’s new fund focusing on no-code tools and others, would do well to simply adopt an indexing approach: define a thesis of what is/is not in your purview, and write a small check into every credible (has a lead VC) deal that comes your way. This builds the greatest chance to back the right break-out company within a strong thesis, while also accumulating knowledge and expertise about an eco-system. I’ll be curious to see if anybody adopts this approach.

But it all hinges on the power law

The dataset here is not neutral. It is “expected” that they find an extreme power law of outcomes certainly in part because AngelList is a platform for exactly this kind of investing. It’s dominated by Silicon Valley investors and folks who read Naval, Jason Calcanis, and other proponents of the style of investing which is all about backing the next Uber or Airbnb.

A principle bet of Earnest is that power law investing is not a law of physics when it comes to early stage investing. We coined the idea of Early Stage Value Investing, to contrast with the kind of Early Stage Growth Investing that happens on AngelList and in VC. Doing a seed deal and then encouraging the founder to hire aggressively at top tier salaries, hit lofty weekly growth metrics, spend down their seed round in 12-18 months, introducing them to VCs to raise more capital if they can achieve those growth rates… all of this make it both more likely that the company will some day be a unicorn AND more likely that it will fail, making the distributions of outcomes a more extreme power law than if you encouraged a founder to hire cautiously, focus on positive unit economics, and get to profitability quickly. See our Fund 2 thesis for the much longer version of this argument.

So in summary, indexing early-stage beats individual picking if you’re operating in an extreme power law environment, but doesn’t make sense if you’re not.

Does Earnest Capital do indexing?

So coming back to the original question and the answer is No, and this whole discussion is why.

1. We’re not doing power law style investing. We don’t expect, and our strategy isn’t predicated on the idea, that one or two investments will be 90% of our returns. We are maximizing the number of successful entrepreneurs in our portfolio. So the idea that the index will out-perform loses efficacy the less extreme the distribution. The AngelList paper found that in later stage deals, when the distribution of outcomes becomes less extreme, the effect goes away.

2. We’re clearly doing something much closer to active management / picking. In doing our first 20 investments, we looked at over 2,000 opportunities. Yes I know this is a vanity metric, but it’s relevant here because we’re just obviously not “indexing” this market with that kind of ratio. We could probably have invested in ~100 of those with more capital, but a very large number of the opportunities were not viable investments (or at least not yet).

3. There really is no benchmark for credible deals in our space. Public stock indices need the public market traders (and subsequent market caps) to know which companies to include in the index. Indexing requires some sort of external form of validation. In our market the only thing comparable would be customer revenue, which is is a great form of validation but there are still plenty of businesses that get to $1k-5k in MRR that wouldn’t make for great investments. We have to be our own form of validation (maybe some day somebody will index us with a Fund of Funds?). Essentially, you can’t index something that doesn’t already have a robust market of active managers creating a good threshold for credibility and that is definitely not the case in the “funding for bootstrappers” market.

So we don’t do indexing. We’re actively betting on the opportunities we think are most likely to succeed. So far that’s going pretty well but we’ve got a lot of ways to get better too.

 

The Entrepreneur’s new path of maximum optionality

“Bootstrap a lifestyle business, strap yourself in to the VC roller coaster, or take out a loan with a personal guarantee and risk losing everything if the business fails.”… For as long as I have been an entrepreneur this was pretty much the menu of options available to most founders of software companies. Before you even tested the business you had to commit to one path and hope you chose wisely. Choose incorrectly and you could kill an otherwise great idea by setting yourself down the wrong path. Raise VC for a business that tops out at $10m a year in revenue; you’re headed for zombie status or a forced acquihire. Carefully build a small profitable business; well you’re obviously not the kind of ambitious dent-in-the-universe founder VCs want to back, so get ready to burn through your savings. Good luck even getting your local bank to talk to you about a loan to start your new SaaS business; you’d be better off asking them to finance the 5th Taco Bell in town.

But recently, a proliferation of new tools and funding options are creating more pathways for entrepreneurs to build and fund software companies while maintaining flexibility and optionality. Let’s follow the path.

0/?You find a unique pain point and have an idea for a product that will solve it

What you don’t do is put together a pitch deck, finagle a multi-billion-dollar total addressable market and spend the next 6 months fundraising. You know that for all the new “pre-seed” funds popping up and all the talk about how “it’s never been easier to raise money” that fundraising on a pitch deck and an idea is a long, hard, time-consuming process that’s unlikely to be successful. Better to just get started on the business without asking investors’ permission. So you do…

1/?‍♀️Launch a minimum viable product and get your first customers

The path starts by just getting started. You work directly with your potential customers and validate that they actually have a problem and want to pay to solve it. Here your options have never been better.

  • You could start a consulting business first. Spin up a simple LLC with Stripe Atlas and use recurring invoicing tools like Harvest or Freshbooks and you have yourself a side-hustle consulting business. From there you can test if there is true willingness to pay in this market and learn more about what kind of product your customers would pay for.
  • Use no-code tools to stitch together a prototype of your product. You could use Makerpad to find the right combination of tools that let you build a software product without code. This could either be a duct taped version that actually does what it says on the label, or a “Wizard of Oz” version that looks and feels like software, but actually you are doing the heavy lifting by hand behind the scenes.
  • You could learn enough code to build the first version. Depending on your learning style, budget, and time, you might prefer coding bootcamps or online tutorial repositories (like Pluralsight or Egghead) or both. Starting with a product to build is the best way I know to stay motivated while learning to code. Even if the product fails, you will have learned a valuable skill.
  • You launch your MVP and get your first customers.

2/?$2-5k MRR (monthly recurring revenue): “rent money” and growing

Your product is live, people are paying for it. Those people stick around (retention) and more people continue signing up (growth). You’re in business now. Once you get to a few $1,000 in monthly revenue, “rent money” level, you have several options on how to proceed.

  • Continue to bootstrap the business on the side. If you can continue to balance a job or freelance work, you can run your business on the side and keep it growing until it generates a full-time income for you.
  • You could go “digital nomad” and move somewhere like Thailand, Bali or Budapest, with a very low cost of living and where your new product can support you full-time. This isn’t an option for many people with a mortgage or family to take care of, but for the right entrepreneur it can be a great way to cut your personal burn rate and keep your options open.
  • With this traction you could raise $50k-150k on a Shared Earnings Agreement (or SEAL) which would allow you to go full-time 1 on your business. A SEAL is designed to bring on investors who will back you early on and let you decide later whether you want to build a profitable sustainable business or a high-growth rocketship.
  • At this point you would likely have a great shot at joining your accelerator of choice. But know that most accelerators’ business model is predicated on getting as much of their cohort funded by VCs as possible. If pivoting the business to larger markets, focusing on short-term growth, and honing your pitch to maximize your raise on demo day isn’t what you want, either skip the accelerators or be very clear upfront that you aren’t sure you want to go down the VC path… yet or ever.

3/ ?$5-25k MRR: ramen profitable + team

You choose a path that gets you working on the business full-time. You start to get initial product-market-fit and feel like your product really solves a genuine pain point. You find a few channels of organic (ie free) growth and begin hiring your first team members. This gets you to “ramen profitable” where you can pay the founders a reasonable salary, at least to where you aren’t burning through your savings or the capital you raised. So what will you do to power the next phase of growth?

  • As always, you can stay bootstrapped, grow organically, hire slowly, and run a Calm Company. This is particularly good path if you have a product with high retention, good free sources of new customers, and you are focused on a niche without too many direct competitors.
  • But maybe you want to make a few key hires—a top tier marketer, the first person in outside sales, or a senior engineer to take the product to the next level—that current cashflow can’t support yet. New funds like Indie.vc and Earnest Capital 2 are ready to back companies at this stage that want to stay focused on building real, profitable, sustainable businesses. You could raise $100k-$500k to see if you can meaningfully change the growth of the business while still planning to return to profitability.
  • You might run some growth experiments, either with your own cashflow or the capital you raised from Earnest or Indie, and discover that there are a ton of ways to turn cash into growth for your business. Now might be a great time to raise a few million in a Seed / Series A venture round on much better terms than before you had this traction.

4/ ?$25- 100k MRR: maximum optionality

You continue growing the business with several proven channels for customer acquisition. You have a minimum awesome team in place that can ensure the product is the best in its class. Somewhere in here you hit or have line of sight to a $1m/year business with a diversified customer base and likely some nice profits. If you’ve gotten here without taking too much outside capital, you have navigated the path to maximum optionality because the number of options for taking your business from here are numerous. You could:

  • Keep funding your business with the most optimally formulated fuel that keeps you absolutely focused on building the best product you can: customer revenue.
  • Somewhere in this range, the traditional banking system3 will finally become helpful. You’ll be able to fairly easily access a $100k line of credit or $50k+ in credit card limits to alleviate any short-term cashflow constraints.
  • You may still want to bring on some more long-term aligned investors for a mix of patient capital, mentorship, and network. In which case the funds from #3 are still a good option, but you could also probably do a large enough raise that a priced equity round might make sense.
  • A huge array of specialized revenue-based financing lenders are now interested in your company. Folks like Lighter Capital, SaaS Capital, Bigfoot Capital, TIMIA Capital, and RevUp will lend upfront capital in exchange for a percentage of your monthly revenue. Unlike traditional banks, these funds do not require a personal guarantee. They are debt instruments and typically become really viable around $50k MRR when the business has become fairly proven and predictable.
  • You might also find that your business has a few “money machines” where you can plug money in and get more money out. Specialized funds like Clearbanc, which will finance your paid marketing budget (ie Facebook or Google ads), or Braavo, which will finance your receivables from app stores, are available.
  • ☝️All the options to this point are not mutually exclusive and can be layered on one another in whatever way makes the most sense for your business.
  • But also, at this point you could likely sell your business for a life-changing amount of money. You’ve kept most or all of the equity in the business. You likely don’t have a board that can block a sale or giant liquidation preferences that make a sale for a few million unattractive. Even if you don’t sell, knowing that you could at any time is a powerful source of freedom.
  • Or, you could look at your $1m/year business and realize at this point you are in or adjacent to a $1B market. You are a proven founder. Your product, sales, support teams are well-oiled and scaleable. You talk it over with the team and decide to shove all your chips in and raise a monster round of VC on far more attractive terms than you could have at the beginning of this process. You could, but you absolutely do not have to.

5/ ?To Rocket or Not

The beauty of all of these options is that most of them can be mixed and matched. Entrepreneurs now have far more choices and paths that allow them to test the market, grow their business and move forward with or without funding. The choice is up to you.

This is the entrepreneurs new path of maximum optionality.


  1. Disclosure: I am the founder of Earnest Capital, which created the Shared Earnings Agreement

  2. Again, full disclosure, I run Earnest Capital.

  3. at least in the US

Selling My Bootstrapped SaaS Business

Five years ago I built and launched the first version of a SaaS app on a single flight from San Francisco to Buenos Aires. Slowly and steadily, Storemapper grew into a healthy location-independent business for one person and then later a small dedicated remote team. At parties, I would describe it as, “not a startup; a healthy growing internet small business.” This year, almost exactly five years after launching, I sold the business for what, to someone growing up middle class in Florida, is a life-changing amount of money that will enable all kinds of exciting new projects and adventures. From start to finish, it has been an exciting ride, much of which I have documented here on the blog. With the sale concluded, I wanted to share as much as I could about the process of building a business that can be sold and how I sold it.

There’s always a risk that these posts turn into a 5,000-word humblebrag. But I really do think it’s worth a read because, unlike most business acquisition stories, which often feel like an out of the blue stroke of good luck, the way that I sold Storemapper feels very replicable for other entrepreneurs. When I spoke to someone two years ago about what it would look like if I ever sold the business I would say, “I’m not trying to sell it now, but if I ever did it would probably look this…” And six months ago I would tell a few folks privately, “I think that one of the people I met recently might be the one to buy Storemapper and if they do it will probably go like this…” And, then basically when it all went down it looked more or less like… that. There wasn’t some single huge stroke of good luck, though of course, I got lucky in the little ways that every successful business has to. An excellent outcome, but also a perfectly reasonable and achievable one that I think can serve as something of a template for other bootstrapped entrepreneurs.

This is a long and detailed post. I had so many questions going into this process and I didn’t find a ton of good posts from the founders perspective on selling bootstrapped businesses. So I thought I would just throw everything I could think of into a post and let you skip around or save it for reference when you’re considering selling your own business. Grab a pot of coffee and let’s get started.

First the obvious: why sell your software business?

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How to Get Startup Ideas: The Meat Grinder Approach

There are a million books and blog posts on how to get startup and business ideas. Many people think the biggest road block to successful entrepreneurial life is having that one great idea. Once you get even a modicum of success, lots of people will start asking you about how you got an idea like that, and for any tips and tricks on how to “come up” with a similar idea.

The concept is extremely tantalizing and sounds so imminently teachable that it’s a favorite tool of lifestyle business spammers everywhere. 7 Step Guide to Profitable Business Ideas. Join My Webinar on Finding Your Dream Business Plan.

But this is entirely the wrong way to think about it.

First of all you should be coming up with at least five possible business ideas every day. This part should be basically effortless. People trying to sell this part are scamming you.

If you are going to be a successful entrepreneur at all you should innately be looking around you at your life and the lives of others, thinking what are their problems. What are their desires. What do they spend money on. Which of those things are broken or could be done massively better or cheaper or faster. You should be constantly thinking this way. It should annoy people who spend a lot of time around you.

If you’re not doing that, you’re probably not going to be an entrepreneur… sorry. It’s okay. There are lots of other great life paths but this one isn’t for you.

There is one common exception to the rule. You might be hung up on one idea, and that stops the process of thinking of new ideas. It’s cool, you just need to build yourself a better meat grinder.

The secret to coming up with a successful business idea is putting hundreds of ideas through the meat grinder.

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