SoftTech’s Hudson Talks Strategy, Key Factors in Out-of-Town Deals
When SoftTech VC partner Charles Hudson came through San Diego last month, he explained why his firm is increasingly taking bigger stakes—and bigger risks—in funding early stage tech companies. He also explained what SoftTech is looking for when it invests in startups outside Silicon Valley.
As one of the first “micro VCs” in the Bay Area, SoftTech has been part of a huge wave of increased venture funding for Web 2.0 startups. According to MoneyTree data, venture funding for Internet-specific deals hit $7 billion in 2013—a 63 percent surge from $4.3 billion in 2010. Of course, most of that capital has flowed into Silicon Valley.
SoftTech was founded in 2004 by Jeff Clavier, a French software engineer, entrepreneur, and fund manager. Through the first two funds (SoftTech’s Fund I invested less than $1 million and Fund II was $15 million), Clavier operated mostly on his own—closing on almost 90 investments in search, social media, online communities, and application infrastructure.
SoftTech’s status as a micro-VC and “one-man band” began to change in 2010, when Clavier brought Hudson in as a partner and hired Stephanie Palmieri (who is now a principal with the firm). Hudson got his start working in the venture business at In-Q-Tel, the CIA’s nonprofit venture fund arm, and later worked at IronPort Systems, an anti-spam appliance maker acquired by Cisco and Google. Before joining Clavier at SoftTech, Hudson was a co-founder of the mobile games startup Bionic Panda Games, and vice president of business development for the social gaming company Serious Business (acquired by Zynga in February of 2010).
SoftTech began investing from its fourth fund earlier this year, after raising $85 million in a continuing transition to a more-traditional venture firm. SoftTech now has offices in San Francisco as well as Palo Alto, CA, and Hudson said the firm makes about 80 percent of its investments in the Bay Area.
The other 20 percent of its portfolio represents an opportunity for Internet startups outside Silicon Valley. In recent years, the firm has invested in San Diego’s TakeLessons, Boulder, CO-based SendGrid and Gnip (acquired last month by Twitter), and in New York’s Chartbeat and Handshake. Still, only a small percentage of companies get money from SoftTech. During a roundtable discussion with San Diego entrepreneurs, organized by Xconomy and San Diego Tech Founders, Hudson said, “Last year we saw 3,200 new opportunities, and we invested in 18.”
Such investments reflect how SoftTech’s strategy has shifted in recent years. Since 2007, “we went from a $15 million fund to a $55 million fund, to an $85 million fund,” Hudson explained. “It’s almost 5x over seven years in terms of fund size. It’s changed the way that we—and most of our seed brethren—think about the market.”
At the end of 2010, Hudson said SoftTech was making “18 or 19 investments a year, and our average check was probably $300,000. The average seed round was probably $750,000 to $1 million, and if you were if you were doing a $1.5 million seed round, that was a big round.”
At that time, he added, “the feeling was ‘Hey, it’s a seed round at a million bucks. We’re all professional investors. If this doesn’t work out, we’ll shut this thing down or we’ll flip it to Google or Twitter, and we’ll move on.’ ”
But now the firm’s seed-stage and Series A deals are substantially bigger. Hudson estimated that SoftTech’s average seed-stage company is now probably raising between $2.5 million and $3.5 million even before it gets to its Series A round. The round dynamics are different too, Hudson said, because it’s one thing to put $250,000 into a company and another to invest a million or two. The stakes are higher for everyone.
“We had companies in 2010 that come in our office, they need $500,000, they need a little bit more help on the prototype. It’s early. [In those days,] we probably would have written that check and supported that company. Now I tell them, what you really should do is get $500,000 in angel money, build that prototype, make some progress, and then come back to us when you’re looking to raise that $1.5 million to $2 million seed round.”
What’s more, Hudson said, a funding process that used to be very orderly, with discrete funding events, has become far more chaotic. Now startups are doing more intermediate seed-stage deals and the complexity has increased, so that companies are now more or less continuously fund-raising before getting to the Series A round.
“We had never factored into our [investment] model that companies would be raising $15 million Series B rounds on relatively modest revenue run rates,” Hudson says. “That’s really changing the way we think about financing, because we tend to see that our companies with a lot of momentum and enthusiasm in the market are able to raise really large rounds.”
Such changes also mean less capital for everyone else. If you’re not part of the top 1 to 5 percent of startups in the market that are fund-raising at any one point in time, Hudson said, “you have this polar-opposite experience, where it’s just very, very, very hard to get people to take the meeting and be interested.”
So how can early stage companies get investors’ attention? Hudson pointed to a couple key factors:
“One is the founder’s strength and vision,” Hudson said. “I know it sounds really fuzzy, but our founders who show well in front of VCs and who have a clear articulation of the vision and who come across as competent, strong, visionary, big plan, big idea—those folks seem to be able to raise money in spite of what I would describe as limited traction.”
The other factor that Series A investors really care about is market size. Not necessarily the total market, but rather the perceived market opportunity, Hudson said. There are some sectors, such as edtech, music, and games, where venture investors have simply lost interest. In contrast, VC interest remains high in drones, wearables, and the Internet of Things.
(It’s worth noting here that other early stage tech investors aren’t necessarily seeing the changes Hudson describes. When I asked Jason Mendelson of the Boulder, CO-based Foundry Group about it, he wrote in an e-mail, “We haven’t seen any material differences in our world. I think there are many more strategies for getting early capital (angel, crowdfunding, etc.), but from what I can tell, the overall business has not changed.”)
When SoftTech looks outside of Silicon Valley for promising companies, Hudson said they consider some additional important factors.
“My biggest concern about investing outside of Silicon Valley isn’t the quality of the company or the founder,” Hudson says. “It’s really two big things: [The first is] access to skilled, experienced talent. Every market is different. In Toronto, you have no problem getting engineers from [the University of] Waterloo. The problem there is in product management and marketing, especially on consumer-facing things. It’s just not a deep pool.”
Nevertheless, Hudson says the number of really good companies in Toronto is growing. “I think the thing that really started to change peoples’ minds is that Waterloo companies started getting into Y Combinator.”
In Boulder, Hudson says the problem is “getting enough of everything. They have really good people in Boulder. We have some great companies there, like SendGrid and Gnip. It’s just that there are more really good startups and founders in Boulder than there are engineers, designers, UI people to support them.”
The second big requirement Hudson identified is being able to step in if there’s a problem and the CEO needs mentoring, or even just a shoulder to lean on. “Local support is the other thing I worry about. We have founders, especially at seed and early stage, where you just have to go see them. When we’re investing out of market, we really like to have somebody around who can do that.” He later added that once a firm has invested in three or four startups in a region, “you can justify doing the fifth because you’re going to be there anyway.” It’s harder to justify making a trip to visit just one company.
To build that initial level of needed trust in another region, Hudson says SoftTech needs a key local entrepreneur or investor who can help SoftTech figure out the market.
“In Toronto, we had a portfolio company exec who was from Toronto,” Hudson recalled. “He said I’m going to go back to Toronto to work for this company, and you should take a look at it. [I said] I don’t really do Toronto, but I think you have excellent judgment. If you’re going to go there, I want to know more about it.”
Asked for his perception of the opportunities in San Diego, Hudson said it seems to be one of those innovation hubs where it is “just too nice.” Such places often have one or two iconic companies that help to reassure out-of-town investors that they can make money. Qualcomm certainly qualifies on that score, Hudson said. But he could not point to any Internet companies in San Diego that have built a high-profile consumer Web business. As a result, San Diego is a tougher sell to investors.
In contrast, Toronto has had a flurry of successes with companies like Shopify, Wave, HootSuite, and FreshBooks, Hudson said.
How could San Diego do better? “Part of it is just a marketing effort and getting the word out that there are good, interesting companies here,” Hudson said. “The other thing is that it just takes a little more local capital. That would probably help. My sense is that there aren’t as many folks here writing seed-stage, angel, Series A checks as there are in other markets. But that’s a chicken-and-egg problem. Once you’ve had people who are successful in technology, they tend to want to plow their money back into it.
“Every city has got to have its thing. It’s taken L.A. awhile, but I think they’re doing consumer now as well or better than the valley. They’ve figured out e-commerce. And if there’s money to be made at the intersection of technology and digital, they’re doing it.”
More than anything else, Hudson said that a few successful exits would “just really change everything” in San Diego. A couple of IPOs, or even some buyouts, would answer the question that lingers in the back of every venture capitalist’s mind—and that question is, could we build a big company in a city like San Diego?