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Entrepreneurs struggle to handicap VCs during the fundraising process – something we see all the time in our portfolio company fundraise cycles. When you combine entrepreneurial passion, tenacity and emotion with typical elusive VC behavior, most entrepreneurs grossly over-estimate actual VC interest.

Why are VCs so difficult to read? As Chris Yeh points out, one answer is that VCs don’t like saying “no” because we want to maintain option value. The idea is that if a VC say no, she may never see the opportunity again – even when it’s ready for her money.  This wastes a lot of entrepreneur and VC time, but is a reality in the market. At HPVP, we say “no” (or no for this round) in most initial meetings where there isn’t a fit, and entrepreneurs seem to appreciate it. But we also make mistakes and let deals drift….

Chris says the best way to measure VC interest is whether they put in time or money. By the time you get the money, it’s too late to handicap! So how do you measure time?

This is how I advise our portfolio companies on handicapping VCs

Early in a relationship with a VC, these all mean NO:

1. They said they will bring the deal to their partnership on Monday and get back to you.

In most cases, this leads to a no or one of the four slow “no” outcomes below. VCs know quickly when they like a deal and will usually schedule a follow-up meeting with themselves or another partner without having to go to the dreaded “partner meeting”. Exceptions: If you’re talking to an associate, this might be the firm’s process. If so, make sure the next meeting is with a partner.

2. They said “Let us know when you find a lead”

If they don’t have the conviction to lead or aren’t willing to help you find a lead (if their fund is too small), the VC is not interested in investing time or money. Exceptions: If the VC has a stated Seed Program – where they invest money in small rounds others lead – they might actually be interested. But don’t invest more time until you have a lead! Really.

3. You haven’t broken through associates to a partner(s)

Sell to power. While there are some associates who have juice at venture firms, you need an investment of partner time for your deal to go anywhere. Exceptions: none

4. They move a meeting other than your first

Yes, we all know VCs are bad about moving meetings. I’m guilty of this too. Don’t worry if your first meeting is moved. The VC doesn’t know how awesome you are and what he is moving. If he moves your second or third meeting, however, consider it a NO. Exceptions: Sickness or death

5. Silence: Echo, echo, echo. Exceptions: none

Let’s say the VC has been good about everything above, has invested time, made talent and customer intros to be helpful and generally seems to be moving the ball down the road. Must be headed towards a term sheet, right? Not necessarily. Maybe they just like you. Maybe they don’t know yet.

If the following are negative, you’re not getting a term sheet:

6. Have you met their partners? Have they met yours?

VCs invest in teams, not just the CEO. If they haven’t met your team, they aren’t serious. The reverse is true as well. Exceptions: none

7. Have they visited your office?

An office visit is basic hygiene in due diligence. So if they haven’t visited, they probably aren’t serious, nor are they selling themselves well. Do you want to work with a VC who doesn’t want to come to your office and always summons you to his? Exceptions: A VC who is long distance might legitimately be interested without a visit but only if they’ve met most of your team some other way. But if they never visit even after a term sheet, do you really want to work with them?

8. Have you talked key hires and board structure 1:1?

These conversations are akin to talking kids with your girlfriend or boyfriend six months into dating – matching cultural values, playfully testing each other on what the future could be like. Board structure also needs to go in a term sheet! Exceptions: rare

9. Have they asked for your cap table?

If they haven’t seen your cap table, it is very hard to write a cohesive term sheet because they won’t understand your current capitalization and option pool. Exceptions: I’ve seen a few term sheets so simple they could have been written without a cap table, but this is very uncommon.

10. Do you feel comfortable texting or calling the VC? And they you?

If your rapport is not already evolving to a working relationship, it is very unlikely that a term sheet is coming. People invest in, and conversely take money from, people they trust. Trust is built through familiarity and informal communications as well as formal ones. Exceptions: Probably quite a few. Everyone has different communication styles, but this is still something to consider.

So, stop wasting time with VCs who aren’t serious, and don’t be shy about calling them to the mat. Challenge the VC to meet your team, you theirs and to visit you. If they pass on these activities, pass on them.

Silicon Valley, meet Ann Arbor, Michigan. Yes, Michigan.

I’ve been spending time in Ann Arbor for several years. It was one of the first cities beyond Chicago we went to source deals when we started Hyde Park Venture Partners. Why? Lots of ideas, talent and willingness to take risk, but very little capital. We invested in two deals there – FarmLogs and Stratos Card – in our first 18 months.

Then a funny thing happened: on every visit, I’d meet another VC opening up an office there. Sometimes a new fund and sometimes an out-of-state fund seeing what we saw. There is now even a shared space just for VCs across from my favorite lunch join, No Tai! (exclamation point part of the name… it’s that good)

A few months ago, I thought “you know, I bet this is the highest concentration of venture capital in the country”. Yup. Here’s how the math stacks up between Ann Arbor and the seemingly more likely Bay Area. Wow!

For nerds: Active capital for Ann Arbor based on size of active current funds with an office in the city. Active capital for Bay Area based on $30B (source: SFgate) of US venture capital deployed in 2013 multiplied by portion deployed in Bay Area of 50% (source: CBinsight) multiplied by investing life cycle of venture funds of about three years. Not exact math but close. Populations from US Census Bureau via Google.

This is not to say every startup in SF should up and move to Ann Arbor. Entrepreneurs raising capital have to kiss a lot of frogs. There are still a lot more frogs to kiss in the Bay Area. With the outcome of each kiss being very very low probability, the more kisses, the better. But these stats are still a very positive sign for Midwest entrepreneurs and investors. It would be hard for an Ann Arbor entrepreneur looking at these stats to point at capital as the scarce resource keeping them from growing their business in Ann Arbor. Of course some of this is stage dependent. Some of the capital in the Ann Arbor figures is mid-stage venture capital – one of the reasons the market is still attractive for my Seed and Series A fund despite the crowds.

What is so special about Ann Arbor?

Ann Arbor is one of the most concentrated pockets of talent, thought leadership and willingness to take risk in the country. This is what happens when a world renowned university draws talented students and their spouses/partners into its gravity… and then often retains graduates locally who love the smart but quaint college town life. Four of the five most active venture markets outside of the Bay Area are college towns:

Source: Martin Prosperity Institute, Startup City, 2013

There is more to the story in Ann Arbor than just being a college town, however. With Michigan’s factory and union labor economy past its prime, a number of public and private initiatives are working to draw technology and innovation to the state. Many of the firms in the chart below were seeded, partially funded or attracted to Michigan by a set of State of Michigan backed funds of funds. The private backed Renaissance Venture Fund has also played a huge part in attracting out-of-town venture funds to setup shop in Michigan and Ann Arbor.

Source: VentureSource, public articles. Data labels represent values for recent active funds.

Now compare the above chart with the same for Chicago, a city almost 100x Ann Arbor’s size. Ann Arbor is clearly doing a great job bringing in capital.

Source: VentureSource, public articles. Data labels represent values for recent active funds.

So, has Ann Arbor cracked the recipe to success outside of the Valley?  

Not quite. Capital is an important input to growth – as is raw talent. But so are customers, acquirers, experienced talent, “critical mass”, and (early on) community leadership.

Customers and acquirers: For B2B startups, college towns will always be light on customers, though proximity to a major airport helps. For B2C startups, college towns can actually be a viral petri dish to test a new product. You’d also think college towns would be light on acquirers, and 15 years ago this was true, but no more. Many large tech companies like Google, Yahoo and others have college town campuses for the same reasons startups do – access to raw talent. Startups and VCs can take better advantage of these relationships and work to bring companies’ corp dev reps into town to see the local tech startup offerings.

Experienced talent: Startups can seed with raw talent but need experienced talent to add to management and leadership layers to scale. Finding these people in or attracting them to Ann Arbor is tough, though not impossible. This is the biggest challenge to growing a startup in Ann Arbor and many other college towns.

Critical mass: Startups are fissile material. You need to get enough startups close enough together for the chain reaction to take place. I am amazed at how many of the startups I know in Ann Arbor don’t know each other. Normalized for size, we don’t see that in Chicago, where founders and employees are well connected and exchange information much faster. This leads to faster failure (a good thing), faster formation of new startups and better exchange and utilization of talent.

Critical mass is created offline and online. In Chicago, 1871 and Builtinchicago have respectively acted as launch pads for the Chicago ecosystem to take off. I haven’t seen this in Ann Arbor yet. Tech Brewery is an amazing and affordable location for startups to seed, but it is not quite a community centerpiece, partly because it’s not downtown. I’m hopeful that the recently launched MadeInA2 will be the much needed digital hub and would love to see an 1871-like facility built downtown.

Leadership: Fledgling startup communities need strong leaders to get off the ground. Fortunately, there is a lot of organic community leadership in Ann Arbor working on the challenges above. Dug Song, CEO of DuoSecurity, Guy Suter, formerly of Barracuda Networks, and Jesse Vollmar, CEO of FarmLogs – as well as a number of VCs – are scheming more and more (the positive English version of the word). Keep it up and let me know how I can help!

The “real” product market fit (PMF) that startups seek is a SCALABLE SOLUTION to a BIG problem in a BIG market. In SaaS, PMF is when you can add and retain $20K/month in MRR at the same cost as the $5K/month you added 12 months ago. It’s rare, but it happens. And it’s beautiful. We are investors in 15+ SaaS companies, and have found there are often false positives in the journey to “real” product market fit.  Here’s what we’ve learned, much of which applies to any startup.

1. You have ten to twenty customers… and have for a while

Most commonly, this manifests as founders selling to “friendly” former customers/clients, but being unable to expand to cold prospects.  Sometimes this is startups selling an SMB solution to lots of other startups in their accelerator or accelerator alumni family. I call this a Ponzi Scheme (!!). But this type of false positive can happen even without “friendly” sales. It just might be you found 15 customers – and not 16 – because the product doesn’t solve a problem for many.

Solution: Look for larger schools of fish nibbling at your product but not buying. Solve their problem.

2. Founders sold the product but the sales people you’ve hired can’t figure it out

Founders have infinite passion, and passion is contagious. Founders may be able to sell a product that hired guns can’t because the founders can share the future vision and sell that. Hired guns need to sell what’s on the truck. If it’s not working, it means the product is missing key features or isn’t hitting a real pain. Of course there’s also the chance you hired the wrong sales people – an issue that is often confounded with a PMF issue. You can sort the two out by having some advisors with related sales expertise observe your sales team in action and peruse your pipeline.

Solution: If not a hiring problem, spend more time with potential “cold” customers to understand their needs.

3. Services are > 25% of your revenue

If the service layer on top of your software product is thick, you might be faking product market fit by customizing the product for every customer. This is typical early on – especially in enterprise SaaS – but needs to decline rapidly to successfully scale.

Solution: There are two root causes behind this type of problem. The first is that the product doesn’t have the right features, integrations or workflow for a critical mass of customers. This is solvable by developing these features as you learn from your early customers what is important. The second likely root cause is that the target customer/market prefers buying services instead of software. This is a harder problem to solve and common in non-techie industries (examples: food manufacturing and event planning).

What is normal for a service layer? Below are some helpful stats from the Pacific Crest 2013 SaaS Survey. A typical professional services layer (as a percent of 1^st year ACV) is 21% for enterprise and much lower for SMB and Very Small Business (VSB) SaaS.

Professional Services (% of 1st Year ACV) by SaaS Customer Type

Source: Pacific Crest 2013 SaaS Survey

Services can either be implementation or ongoing services. Almost all enterprise SaaS has implementation services associated with it. Many successful SaaS companies like Salesforce build consulting ecosystems around them to support implementation. This is a terrific way to externalize the service layer so it doesn’t affect your awesome SaaS valuation multiple. Ongoing services are harder to externalize, though it is done successfully in some industries like advertising and marketing where agencies have built a service ecosystem on top of the software providers.

4. You can’t get access to senior deciders

Inability to access senior deciders – assuming you have a tenacious sales team – is a clear sign that your product or service doesn’t meet a big pain.

Solution: Find a really painful problem to solve.

5. Your first round of renewals goes horribly wrong

I’ve seen first renewal cycle rates as low as 50%. Now that’s a burning platform. This can be caused by lack of or poorly executed post-sales enablement (training, lifecycle marketing, etc), or it could be a PMF problem – your product just wasn’t what your customers had hoped for. You need to talk to your customers to figure out which one it is.

Solution: I’ve written before about improving post sales enablement.  If that’s not the issue, and PMF is the problem, it may be that additional features or better UI/UX solve the problem. Worst case, you’re back to finding a really painful problem to solve.

We often see false PMF rear its head between 25K and 50K MRR just a bit before or after a Series A raise. It’s easy to see a PMF problem when a seed stage company has little to no revenue, but at higher levels of revenue, the revenue itself deceives our simple human brains. When recognized early, false PMF spurs quick corrective action or pivot followed by continued ramp.  When not recognized, teams attempt to muscle through it… pushing a rock up hill. This isn’t sustainable because sales efficiency is very low, revenue ramp is anemic and the company quickly hits cash crunch.

The promise of a technology or idea often seems huge and broadly applicable… horizontal. When done right, horizontal plays can drive huge success for entrepreneurs and investors and span from apps (ex. Dropbox) to deep backend infrastructure (ex. Oracle).

This is why founders ask me regularly whether their company should sell horizontally or pick a vertical. Turns out the answer has very little to do with the technology or product. Here is one way to decide in basic Boolean logic. Explanation after the chart:

Boolean logic to decide if your startup should go horizontal or vertical

Having a broadly applicable technology and productization are only table stakes (in blue) to a horizontal play. The decision is dominated by go-to-market considerations (in green) from pricing, to sales model to post-sales setup.

Pricing power equity is needed across industries to avoid pricing conflict (“why did the manufacturing guy get it for a lower price? That’s not fair”) or leaving too much on the table in higher-willingness-to-pay industries that may take longer to sell.

WORK AROUND – separate brands: Use separate branding and/or slight reskinning of the product to make it seem different to different segments/industries. This trick is used relentlessly in hardware (how different are the innards of a Volkswagen and an Audi?). It works in software too.  SAP does this with its “SAP for [fill in the blank]” industry sub-branding. The challenge as a startup is that with limited resources and time, it is hard to maintain multiple brands and even slight variations in products.

A self-service sales model is the strongest sign that a horizontal play is afoot

In self-service sales, marketing efforts drive prospects through an automated funnel conversion process (whether to freemium/premium or paid). This is a great fit for horizontal plays because any requisite industry message customization is highly scalable. With a small number of industry focused marketing campaigns, landing pages and “use case” materials, you open up your market to many or even any industry. Box.com does this brilliantly. Their landing pages make you feel like Box was made just for healthcare, government, manufacturing, etc. Same exact product and pricing.

Things get complicated when your sales model is people driven via inside or outside sales. Any needed industry message customization is not scalable but specific to the people you hire and their industry expertise and comfort. There are several flags to watch for:

• Educative sale or consultative sale: If the sale requires the sales person to educate or “consult” to the customer (eg, play the role of industry expert), it is difficult to be horizontal and target more than a few industries
• Post sale implementation: Products and services with significant post sale implementation drive verticalization because implementation and customization are often industry specific
• Service layer: If there is a service layer sold with the product or software, it often requires personnel to have industry expertise, driving verticalization

You’ll notice that all of the above are present in most enterprise sales, making enterprise sales models difficult for horizontal plays.

WORK AROUND – the integrator: These complications can be managed and a horizontal model maintained by outsourcing expertise to an “integrator” ecosystem around you, much as Salesforce, SAP, ExactTarget and Oracle did.  Of course, it’s easy to get integrators and consultants interested in your “ecosystem” when you’re a $1B+ company. Harder when you’re a startup. You may have to cut some nice deals to do it.

In making a horizontal/vertical decision there are a few other litmus tests you can consider too:

• Do the buyers/users tend to be very industry specific or do they move across industries? Let’s say you sell into the sales function. Do the sales people and leadership come from multiple industries? If your buyer is horizontal, likely you can be too.
• To make a great product, do you need to integrate with industry specific services and APIs? If yes, you are probably a vertical play!

Don’t worry, vertical plays can be wildly successful too, though it is true that most SaaS unicorns are horizontal (Salesforce, Workday, etc).

Note: This post was originally published on TechCrunch here.

The websites of most VCs have a stated investment thesis in SaaS, cloud, mobile, social or some combination of each. Are these really investment theses? Still? No, they’re realities, and this is worrisome.

While SaaS, cloud, mobile and social have been drivers of big success for many funds and entrepreneurs over the past five years, theses-turned-realities cannot continue to drive outsized returns.

I started thinking about this when reading Tren Griffin’s post on Marc Andreessen. Tren summarizes Marc’s view on venture investing into four quadrants along axes of consensus/non-consensus and success/failure. It’s simple but powerful stuff:

Source: 25iq.com, A Dozen Things I’ve Learned From Marc Andreessen

A VC that continually makes consensus bets is not likely to have long-term success, especially if there are too many execution failures mixed in. The same can be said for entrepreneurs. Another way to think about this is with mock returns distributions:

Consensus bets have a tighter returns distribution, driven mostly by execution. Since execution is all about people, consensus bet returns are about “who.” Non-consensus bets have a longer tail distribution, driven by “who” but also “what,” “when” and “how.” By definition for non-consensus bets, the value proposition (what), adoption rate (when) and business model (how) are very uncertain. Both distributions are heavily right-skewed — most startups fail! But non-consensus bets can lead to huge wins when you get the who, what, when and how right. Think Facebook or Dropbox. Neither were consensus at the time, and they pretty much nailed it.

Mapping the world of investment theses

If no longer SaaS, cloud, mobile or social, then what? I came up with the market thesis map below (click for PDF), which is sectioned vertically for B2B, consumer, healthcare and infrastructure because we work, we consume and we try to live longer, and infrastructure enables all three.

Left to right maps recent startup and VC investment foci along the continuum of Thesis –> Transition –> Reality. A true thesis yields bets that are non-consensus – visions of certain combinations of who, what, when and how that not everyone agrees on. Reality investment focus bets are consensus – just a question of who. As it turns out, many popular “theses” really aren’t theses at all. They’re realities.

Connections proliferate among investment foci because very few technologies and business models are islands in the connected world. For example, 3D printing, an enabling infrastructure technology, has ties through distributed manufacturing into the maker and on-demand economy theses.

There are also influential nodes like mobile commerce, social networking and IoT. Social networking is clearly a reality, not a thesis. The who, what, when and how of social networking are well defined. IoT, on the other hand, is still a real thesis because the winners, winning strategy and timing are still uncertain. Mobile commerce is somewhere in the middle. Outsized returns will be hard in social networking, likely (for someone) in IoT and possible in mobile commerce.

Theses themselves evolve. When technology paradigms transition, there is always opportunity to rejuvenate a thesis. This is how SaaS (now a reality) spawned the mobile SaaS thesis (now in transition). The great paradigm changes we’ve seen in the last four decades are: Offline –> Mainframe –> Desktop –> Cloud –> Mobile. (Mobile may now evolve to Wearables –> Embedded. We’ll see.) The SaaS thesis developed 12-plus years ago when the desktop paradigm began transitioning to cloud, enabling the SaaS business model and creating monsters like Salesforce.com. Now with the mobile paradigm shift, there are big mobile disruptors in SaaS (like Base CRM) giving Salesforce a run for its money.

So is SaaS as an investment thesis dead? Maybe not. Just as new technology paradigms can renew a thesis, one thesis can be merged with another to create a new one in a kind of combinatorial evolution. SaaS + Social Networking + Geofencing spawned our own investment in Geofeedia. Most theses also start out as horizontal plays; investors fund horizontal plays first because they can be really BIG. As examples, Salesforce, Hubspot and Dropbox are big horizontal industry-agnostic ventures. Once the horizontal bets have played out, however, there remain myriad opportunities to verticalize theses. This is especially true in lagging industries like construction, logistics and agriculture – hence our investment in FarmLogs.

Nevertheless, the greatest returns will likely come from true non-consensus bets in new theses – when a brilliant team and lucky VC find the quadfecta of who, what, when and how.

Note: for more on technology paradigm shifts and the combinatorial nature of technology, see Brian Arthur’s Nature of Technology and Nate Silver’s Signal in the Noise.