From market risk to product risk to execution risk, I’ve written many a time the types of risks a founder takes, including here, here, and here. As well as shared that the first and foremost question founders need to answer is: What is the biggest risk of this business? Subsequently, is the person who can solve the biggest risk of this business in the room (or on the team slide)?
Over the weekend, I heard an incredible breakdown of the other side of the table. Rather than the founder, the three types of risks an investor takes. The same of which need to be addressed for LPs to invest. From Kanyi Maqubela on Venture Unlocked.
Market risk as a function of ownership
Judgment risk
Win rate risk
Market risk as a function of ownership
If you’re investing in an consensus market – be it hot, growing, and is garnering a lot of attention, you don’t need a huge percentage. I mentioned before that every year there are only 20 companies that matter. And the goal of a great VC is to get into one of these 20 companies. Ownership doesn’t matter. Even 1% of a $10B outcome is a solid $100 million.
On the other hand, if you’re in a small or non-consensus market, you need a meaningful ownership to justify your bets. For the same $100 million return, you need to maintain 10% at the time of a unicorn exit.
Going back to economics 101, revenue is price multiplied by quantity. Revenue in this case is your returns, your DPI, or your TVPI. Price is the valuation of the business. Quantity is how much you own in that business. Valuation, as a function of market size, and percent ownership are inversely proportional to reach the same returns. The smaller the market, the more ownership matters. The bigger the market, the less it matters.
Judgment risk
At the top of the funnel, the job of any investor is to pick or to get picked. I’ll take the latter first. Getting picked is often far less risky. But far harder to get allocations for, especially if you’re a fund that has ownership targets, vis a vis the market risk above. At the same time, the larger your check size, the harder it is to squeeze into the round.
To generate alphas from picking, there are two ways:
Get in early.
Go to where everyone else said it’ll rain, but it didn’t. Do the opposite of what people do. That said, being in the non-consensus means you’ll strike out a lot and it’ll be hard to find support.
The question to ask yourself here is: What do you know that other investors are overlooking, underestimating, or altogether not seeing? And how did you reach that conclusion as a function of your experience and analysis?
As Kanyi said on the podcast, “We think we’ve got unusually good judgment and nobody else likes this, but we like it for reasons that are unfair.” The unfair part is key.
Win rate risk
Win rate risk breaks down to what unique advantage you, as an investor, bring to the table that will help the company win. In simpler terms, what is your value add? Of the businesses you say “yes” to, can you increase the number of those who win? As an early-stage investor – angel or VC, there are four main ways an investor can help founders:
Access to downstream capital or capital from strategic investors
Access to talent – How can you increase the output of the business?
Sales pipeline – How can you help grow revenue directly?
Strategy – Do you have unique insight into the industry, business model, product, GTM, or team management that will meaningfully move the business forward?
In closing
If you’re an investor, I hope you found the above as useful of a reframing as I did. If you’re a founder reading this, I often find it useful to stand in the shoes of your investors. And in understanding how your investors think, you can better formulate your pitch that’ll align your collective incentives.
The conversation around risk management, at the end of the day, is a conversation of prevention. A realm of prevention while useful to hedge your bets is a strategy to not lose. It’ll help your LPs find comfort in investing dollars into you. But to truly stand as a signal above the rest and to win, you have to look where other investors aren’t. The non-obvious. Specifically the non-obvious that’ll become obvious one day. And you have to do so consistently.
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Last Thursday, I had an extremely thought-provoking conversation with an attorney-turned-investor. Out of the incredible array of topics our open-ended exploration on the topic of diversity – geographically and demographically – led us to, there was one thing in particular that I had to double click on.
She shared, “Men typically get asked promotion questions. ‘What does your upside look like?’ Whereas women and other underrepresented founders get asked prevention questions. ‘How do you prevent your startup from going out of business?’ And promotion questions begets more promotion questions. Similarly, prevention questions leads to more prevention questions. Founders who are typically asked prevention questions raise less capital than those who are asked promotion questions.”
I found that inextricably fascinating. I’ve never thought about investing through those lens before. It makes complete sense. The more an investor asks how are you not going to fail, the more they has convinced themselves this won’t be a good investment. On the flip side, the more an investor asks how awesome will you be, the more they’ve convinced themselves that this will be an investment worth their time.
And subsequently, I ended up reexamining the way I ask questions. I’ve never tracked the way I ask questions by demographic. But I fear that I may, in the past, have done something along the same veins.
When we closed out our conversation, she left me with one name: Dana Kanze. And well, if you know me, I had to look into her.
She cites in that research that “although women found 38% of US companies, they only get 2% of the venture funding.” While that metric is a few years old, recent trends echo the same notion. Despite the increase in conversations to include diversity at the table, in board rooms and as decision makers, Crunchbase found in a study back in August that women still only get 2.2% of venture funding, which is actually lower than any of the previous five years.
Cynthia Franklin, director of entrepreneurship at Berkley’s Innovation Labs at NYU, did say, “The bets are being made, but they’re smaller.” Which accounts for the fact that 61% of total funding for female founders happens at the early stages. Frankly, it might be too early to tell. Nevertheless, Dana has a point.
Why female founders raise less capital
Originating from E. Tory Higgins‘ regulatory focus, Dana shares the bifurcation of questions that male and female founders get. Promotion and prevention questions, respectively. “A promotion focus is concerned with gains and emphasizes hopes, accomplishments, and advancement needs, while a prevention focus is concern with losses and emphasizes safety, responsibility, and security needs.”
After analyzing nearly 2,000 questions and answers asked at TechCrunch Disrupt to presenting founders, she found that investors often ask male founders promotion questions. And investors ask female founders prevention questions. Specifically, 67% of questions to males were promotion questions. And 66% to females were prevention ones.
Yet I found one notion Dana shared particularly fascinating. “All VCs displayed the same implicit gender bias manifested in the regulatory focus of the questions they posed to male versus female candidates.” That both female and male investors had the exact same implicit cognitive biases against females.
Promotion questions beget promotion answers, which beget more promotion questions, reinforcing favorable opinions. It becomes a virtuous feedback loop, which culminates often times in a “yes”. On the other hand, prevention questions beget prevention answers. Which leads to more prevention questions. This, subsequently, leads founders down a negative feedback loop, reinforcing loss-correlated opinions. When it came down to it, “startups who were asked predominantly promotion questions went on to raise seven times as much funding as those asked prevention questions.”
The silver lining, as Dana shares, is that if founders respond to prevention questions with promotion answers, they raise 14 times more funding than those who answer prevention with prevention. The lesson is reframe your answers positively, betting on the long term potential and vision. Or in Alex Sok‘s words, focus on a strategy to win rather than a strategy not to lose.
In closing
Investors invest in lines, not dots. And often times, VCs don’t realize they’re spending more time analyzing the y-intercept than the slope. And that mentality actualizes in the form of questions founders get.
As a founder, understand your investor intention – subconscious and conscious. Playing off of Matt Lerner‘s language/market fit, find your fundraising language/investor fit. Once you understand their intention, capture their attention. In a saturated market of information, attention is your audience’s scarcest resource. Frame the dialogue with a promotion focus to get your investors over the activation energy to book the next meeting.
As an investor, pay attention to your cognitive biases. Most of the time, and often the most detrimental, are the ones we don’t realize. If anything, this blogpost is me pinching myself to wake up.
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With the crazy market we’re in today, VCs are frontloading their diligence. They’re having smarter conversations earlier. Before 2021, most investors would have intro conversations with founders before taking a deeper dive into the market to see if the opportunity is big enough. Nowadays, investors do most, if not all, their homework before they start conversations with founders. And when they’ve gotten a good understanding of the market and a more robust thesis, then:
They go out finding and talking to the founders who are solving the problems and gaps in the market they know exist.
They incubate their own companies that solve these same issues.
Subsequently, they are more exploratory than ever before. In frontloading their diligence, VCs have become more informed, if not better, predictors of not only where the market is today, but where the market is going to be tomorrow. They have a better grasp on the non-obvious. Or at the very minimum, have a much better understanding on the obvious, so that the boundaries of the non-obvious are pushed further. In turn, they can truly invest in the outliers. Outliers that are more than three standard deviations from the mean.
Startup ideas are often pushing the boundaries of our understanding of the world we live in. The team at Floodgate use an incredible breakdown to frame the amount of data that needs to be present to qualify the validity of a team and idea. “[W]e like to say some secrets are plausible, some are possible, and some are preposterous, all different types of insights. It matters what type it is because the type of team you need, the type of people you need to hire, the fundraising strategy, the risk profile, the amount of inflections that have to come together. All of those things vary, depending on the type of secret about future that you’re pursuing,” said Mike Maples Jr. recently on the Invest Like the Best podcast.
Science fiction is, by definition, preposterous. But so are the true outliers. And as any great investor knows, that’s where the greatest alphas are generated.
Preposterous ideas are backed by logic and insight
To quote PG from an essay he wrote earlier this year, “Most implausible-sounding ideas are in fact bad and could be safely dismissed. But not when they’re proposed by reasonable domain experts. If the person proposing the idea is reasonable, then they know how implausible it sounds. And yet they’re proposing it anyway. That suggests they know something you don’t. And if they have deep domain expertise, that’s probably the source of it.
“Such ideas are not merely unsafe to dismiss, but disproportionately likely to be interesting.”
But no matter how implausible your startup idea sounds, there still has to fundamentally be an audience. And while it may not be obvious today, the goal is that it will be obvious one day. Frankly, if it’s forever non-obvious and forever in the non-consensus, you just can’t make any money there. If Airbnb stuck only with the convention industry or Uber only with the black cab, or Shopify only with snowboards, they would never have the ability to be as big as they are today.
Shopify’s Alex Danco has this great line in his essay World Building. “If you can create a world that’s more clear and compelling than the complex, ambiguous real world, then people will be attracted to that story.”
As investors, we have to start from first principle thinking. Investors, in frontloading their diligence, find the answers to “why now” and “why this”. All they’re looking for after is the “why you.” The further down the line towards preposterous science fiction you are, the more you need to sell investors on “why you”.
Idea Plausibility
Key Question
Context
Plausible
Why this?
Most people can see why this idea should exist. Because of the consensus, you’re competing in a saturated market of similar, if not the same ideas. Therefore, to stand out, you must show traction.
Possible
Why now?
It makes sense that this idea should exist, but it’s unclear whether there’s a market for this. To stand out, you have to convince investors on the market, and subsequently the market timing.
Preposterous
Why you?
Hands down, this is just crazy. You’re clearly in the non-consensus. Now the only way you can redeem yourself is if you have incredible insight and foresight. What’s the future you see and why does that make sense given the information we have today? If an investor doesn’t walk out of that meeting having been mind-blown on your lesson from the future, you’ve got no chance.
And when answering the “why you”, it’s not just on your background and years of experience, but your expertise. As Sequoia’s Roelof Bothaputs it, “So what was the insight? What is the problem that you’re addressing? And why is your solution compelling and unique in addressing that problem? Even if it’s compelling, if it’s not unique there’re going to be lots of competitors. And then you’re probably going to struggle to build a distinctive business. So it’s that unique and compelling value proposition that I look for.” So before anything else, the best investors, like Roelof, “think of value creation before value capture.”
In order to find that earned secret – that compelling and unique secret sauce – in the first place, you have to love what you’re working. And not just passionate, but obsessive. The problem you’re trying to solve keeps you up at night. You have to be more of a “missionary” than a “mercenary” as Roelof would put it. If you’re truly a missionary, even the most preposterous idea will sound plausible if you can break down why it truly matters.
The Regulatory Dilemma
The most important and arguably the hardest part about writing science fiction – and this is equally true for funders as it is for founders – is that we have to self-regulate. Regulation will always be a lagging indicator of technological development. Regulators won’t move until there’s enough momentum.
But, as we learned in high school physics, with every action, you need an equal and opposite reaction. The hard about momentum, and I imagine this’ll only be more true in a decentralized world, is that it’s second order derivative is positive. In other words, it’ll only get faster and faster. On the other hand, regulation follows the afterimage of innovation. It sees where the puck was or, at best, is at, but not, until much later, where the puck is going. And truth be told, innovation will eventually plateau, as it follows a rather step-wise function, as I’ve written before. And when it does, regulation will catch up.
So, in the high school physics example of Newtonian physics, the reaction, in this case, regulation, needs to be equal and opposite force comparative to where the puck will be. But as you’ve guessed, that will stop innovation. And I don’t think the vast majority of the world would want that. Progress fuels the human race.
In fantastical worlds, we are often used to how awesome things can be. Making the impossible possible. But as Brandon explains, “the truth is that it’s virtually impossible to come up with a magical effect that nobody else has thought of. Originality, I’ve seen, doesn’t come so often with the power itself as with the limitation.”
As the infamous line goes, “with great power comes great responsibility.” If you end up having access to every single person on this planet’s data, what makes you a company worth betting on isn’t your power, but how you use that power. How you self-regulate in using that power. Take, Open AI’s GPT-3. Instead of sharing the entire AI with the world, they limited that power to prevent malicious actors through an API.
What does self-regulation mean? Simply, aligning incentives so that all stakeholders win. When you have two people, you have a 2×2 matrix to account for four possible outcomes. There’s a situation where both people win, two situations where one wins, one loses, and another where both lose. Needless to say, we want to be maximizing for win-win situations.
As Balaji Srinivasansaid on the Tim Ferriss Show recently, “When you have three people, it’s a 2x2x2, because there’s eight outcomes, win/lose times win/lose times win/lose. It’s a Cartesian product.. […] When you have N people, it’s two by two by two to the Nth power. It’s like this hypercube it as it gets very complicated.” Subsequently, the greater the organization, the more stakeholders there, and the harder it is to account for the “win” to the Nth power outcome. Nevertheless, it’s important for founder and funders at the frontier of technological and economic development to consider such outcomes. And at what point is there a divergence of incentives.
There’s usually a strict alignment in the value creation days. But as the business grows and evolves to worry more about value capture, there needs to be a recalibration of growth and an ownership of responsibility as the architects who willed a seemingly preposterous idea into existence.
In closing
We live in a day in age that is crazier than ever before. To use Tim Urban’s analogy, if you brought someone from 1750 to today and had them just observe the world we live in, that person will not only be mind-blown, but literally, die of shock. To get the same effect of having someone die of shock in 1750, you can’t just bring someone from 1500, but you’d have to go further back till 12,000 BC. The world is changing exponentially. And new technologies further that. Who knows? In 50 years, we in 2021, might die of shock from what the world will have become.
And rightly because of such velocity, innovators – founders and investors – will have to lead the charge not only technically and economically, but also morally.
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Last weekend, I tuned into Samir Kaji’s recent episode with LPs (limited partners). Not once, but twice. And as you might’ve guessed, was damn inspired by their conversation. The more I listened to it, the more synonymous the paths of a founder and an emerging manager (EM) seemed to be. Or what I call the entrepreneur and the entrepreneurial VC. If you’re a regular here, you’ll know I love writing about the intellectual horsepower of both sides of the table. But in this post, rather than delineating the two, I’d love to share how similar founders and funders actually are.
Surprises suck, but pivots are okay
On Samir’s podcast, Guy Perelmuter of GRIDS Capital voiced: “There’s only one thing that LPs hate more than losing money. It’s surprises.”
Be transparent. Be clear on your expectations, and steer clear of left hooks. As a fund, something I’ve heard a number of GPs and LPs say is don’t deviate on your thesis. LPs invest in you for your strategy. But as soon as you deviate from that initial strategy, you become increasingly unpredictable.
Take, for example, you go to a steakhouse and order steak. But they serve you sushi instead. If it’s not good sushi, obviously you’re not coming back. Not only did they surprise you, but it was also a poorly executed one. This goes in the column of one-star Yelp reviews.
But, say it was great sushi. You had one great dining experience and you’re a happy customer. Some time in the future, you think of getting sushi again. And you remember what a great experience you had at the steakhouse. So you go back to the steakhouse, only to realize it was a fluke and the sushi wasn’t like the last time you’ve had it. Your inability to replicate surprises scares LPs, which limits your ability to raise a subsequent fund.
Nevertheless, these days markets are changing quickly. And sometimes your initial thesis may not serve you as well in today’s market as it did yesterday. As John Maynard Keynes, father of Keynesian economics, once said, “When the facts change, I change my mind.” But, if you do need to deviate, communicate it clearly, formulate a new strategy, and preemptively tell your LPs. Then at that point, it’s no longer a surprise, but a strategy. Great examples include:
Not investing via their fund strategy (i.e. typically ad hoc),
Require less diligence and therefore less conviction,
Send negative signals to other investors if the GP doesn’t do a follow-on check at the next round, and
Because of (2) and (3) are usually cash sinks.
The On Deck Accelerator (ODX) – Backing founders at the earliest stages (i.e. pre-product, pre-revenue) as long as they have deep conviction in their own business.
The recent announcement of The Sequoia Fund – a systematic and predictable strategy to invest in not just startups, but venture funds backing incredible founders as well.
The same holds for founders. Don’t get me wrong. Startups pivot. And they should. Mike Maples Jr., founder of one of the best performing seed stage venture firms, recently shared: “Most investors are going to look at what the company does and evaluate the business for what it is, but 90% of our exit profits have come from pivots.” And just like fund managers, clearly convey why, how, and what you’re pivoting to to your shareholders. It’s always better to preempt these conversations than leave these as surprises. Often times, you’ll find your investors, having seen as many pivots as they have and knowing that is the name of the game, can offer you much more feedback and insight than you imagined for your pivot.
Optimize for the “Oh shit! moment*
In every conversation, your goal should just be to teach your investors something. An earned secret. A unique insight. What do you know that other people don’t, overlook, or underestimate? What do you know that other people would find it very hard to learn organically? This is especially true for consensus ideas – or obvious ideas. The best obvious products may seem obvious at first glance, but usually have non-obvious insights to back them up.
If you’re a fund, what is your insight – your access point – that’ll win you an asymmetric upside?
I’ve talked to too many founders and EMs that claim to be experts with X years of experience in a particular field. Yet after 30 minutes, I realized I learned nothing from them. I realize that for half an hour straight I ended up with a prep book full of buzzwords and vague jargon that would rival the SAT vocab section. But let’s be real. The SAT doesn’t get me excited to want to retake the test.
The best founders and funders out there are able to break down deep, technical, esoteric, and sometimes crazy concepts into simple bitesize ideas. The equivalent of taking the whole universe and simplifying it to its origin. A single point. The Big Bang.
I’ve also realized over the years that the world’s smartest teachers – and when you’re trying to convince people to join you in a non-obvious vision, you are teaching – lead with analogies. And the best analogies lead investors to that “Oh Shit! moment.”
COVID made capital cheaper
Equally true for startups and funds. Capital is digital. If you think about capital in the frame of investor acquisition cost, you no longer have to travel to your investors to pitch to them. This means you can take far more meetings than before. Less travel and more meetings mean your investor acquisition cost goes down.
Founders no longer have to book a week to Sand Hill Road or South Park to have introductory conversations with investors. Only to have 80-90% turn down a second conversation. This becomes even more costly the earlier you are in your startup journey. You have to have a lot more first conversations as a pre-seed founder than you do as a founder raising an A. At the same time, you have many more options for raising capital today: accelerators, syndicates, equity crowdfunding, and roll-up vehicles (RUVs). While it’s not that these resources didn’t exist before COVID, the pandemic made it much more apparent that VC money didn’t have to be the only way to raise capital. And that you can also leverage speed and your community to help you grow.
Similarly, EMs no longer have to travel across the states to talk to institutional capital. Even more so, as an EM, you’re most likely raising from individual investors. Raising a rolling fund or a 506c lets you generally solicit investments, where you couldn’t with a 506b. Subsequently, Twitter and having a community became your superpower. Mac at Rarebreed, Packy’s Not Boring Fund I, and Harry at 20VC all raised during the time of COVID, leveraging the power of their following and community to do so.
Keep it simple
“There’s no favorable wind for the sailor who doesn’t know where to go.” – Seneca
Two Saturdays ago, I caught up with my ridiculously smart engineer friend from college – “Fred”. We were reminiscing about the “good ol’ days” when we first started punching above our weight class. Particularly in regards to cold outreaches to individuals we really admired. While I was an operator at two startups that shaped my entrepreneurial career, I spent many a night struggling on how to best position our products in the market. Many hours of copy and rephrasing and reframing. In both we were competing against the existing saturation of information and solutions on the market. How do we tell our customers and investors the reason we’re awesome is because of A and B and C, and also D?
Most people, friends, customers, and investors didn’t understand the value we thought we were obviously conveying. And subsequently, we were rejected more often than I would have liked to admit. In the early days, we didn’t lose on price nor on quality, but on brand and messaging. And while we thought and strove to prove we were better in areas that mattered, both startups eventually ended up having exceedingly simple one-liners.
On the other hand, “Fred” was working on something related to liquid fuel and cold fires. Something extremely technical. But he was able to win proportionally more yes’s than I was able to. When I asked him how, he said it was simple. “We’re putting a rocket into space. That’s it. And that’s really exciting.”
I made something extraordinarily simple into something extraordinarily complex. In all honesty, I sounded really, really smart. And I felt like I was the shit. Except no one else did. “Fred” took something extraordinarily complex and made it extraordinarily simple. He didn’t sound as smart. But celebrities, sponsors, companies – people just got it.
The true value of a product is usually exceedingly simple. The fallacy of including a Rolodex of esoteric jargon comes in two-fold. Either you’re trying to sound smarter than you actually are. Or you’re trying to cram too many things in too little space. As economist Herbert A. Simon said, “A wealth of information creates of poverty of attention.”
In closing
Whether you’re an entrepreneur or an emerging manager, you’re swinging for the fences. I was chatting with an investor yesterday who had an incredible analogy. “It’s like a pinball machine. The ball goes up, and you never know how it’ll fall down. You don’t know how many bounce pads and flippers it will hit. You don’t know how many points you’re going to get. But no matter how many points you’ll get, the ball has to go up first.” Similarly, whether you start a company or a fund, you have to step up to the plate to bat. You don’t know what the upside will be. You don’t know if you’re going to return your investors 2x, 5x or a 100x.
You’re taking an asymmetric bet on the compelling future you bring. Your valuation as a startup is not how much your startups is worth, which is why the 409a valuation is always different from the valuation your investors set for you. Your valuation is a bet your investors made that you will be as big as the major players in the market. If you’re valued at $10M today, your investors are saying you are 10 in 1000, or a 1% chance, to be a unicorn. And a 0.1% chance to be a decacorn.
Valuations might seem crazy today. VC firms are also raising larger and larger funds, which lead many to be skeptical on their ability to return capital. In fairness, most funds will return a modest 2-3x over their lifetime, if at all. Most startups are and will be overvalued. On the same token, the best ones, despite their crazy price, are still undervalued. Imagine if you were an investor who could invest in Facebook’s then-unicorn valuation. You’d have made a lot of money. But we’re in an optimistic market.
At the end of the day, both parties are just managing someone else’s capital. And as such, through a fiduciary responsibility, in that regard, both are cut from the same cloth.
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Last week, I had an incredible fireside chat with GC’s Niko Bonatsos, who has played a key role in some incredible investments, from Livongo Health to Snap to Wag! and most recently, Saturn. In all honesty, I took much of that experience to scratch my own itch. As always, we ran out of time before we ran out of topics. But I was lucky enough to ask one of which I happened to be losing sleep over. “How do you balance speed and diligence in the increasingly competitive market of venture?”
COVID changed us
In the midst of the pandemic, COVID became a forcing function for investors to deploy capital without ever meeting founders in-person. Frankly, they couldn’t meet anyone in-person. Even if they wanted to, investors, like everyone else, was subject to a series of lockdowns, curfews, and eventually the vaccine.
Yet, as life returns to a sense of normality, many investors have gotten comfortable investing virtually. And for a handful, only virtually. At the same time, in today’s increasingly competitive venture market, capital’s become more of a commodity. And I’ve heard a number of LPs find speed to be a competitive advantage. As a product of speed, investors compete on shortened timelines. It’s a given for angels and super angels out there who have to have conviction on a fairly limited set of data. But how do top-tier funds compete in that same market yet maintain the same discipline as before?
I got my answer from Niko.
“We try to pre-empt the stuff we really care about. It basically translates to us being prepared, having frontloaded a lot of the diligence for the companies and opportunities we care about. We have a more educated conversation with the founders, and are the first ones to get to a term sheet than anyone else. That’s something we do a lot more often. And we’ve leaned into seed, which is the new series A.”
Moreover, with all the diligence they do prior to sourcing, funds, like General Catalyst and Founders Fund, have started to incubate startups where they couldn’t find solutions to problems they found.
Slowing things down
Earlier this week, over a lunch, I posed the same question to Fort Ross‘ Ratan Singh, from whom I got a slightly different variation. “VCs are doing their homework before every meeting and going in with a thesis so that they can deploy fast. VCs used to play catcher and do all their homework after the meeting. But now it’s changed, so they can say yes faster.
“While speed is a differentiator, things are moving too fast today. I met every founder I’ve invested in in-person. Even during the pandemic, I invested in seven founders, and every single one I’ve met in-person.”
To which, I had to ask, “What do you find out from meeting a founder in-person that a virtual meeting lacks in?”
Without missing a beat, Ratan said, “It’s in the small things. The way they interact with their teammates. The way they treat each other. As we finish our chat and walk back to the car, are they still an intelligent being outside of the script? A Zoom call is a 30-minute scripted call. There’s a deck. There’s the presentation they prepared. An in-person interaction is more than that.”
Ratan’s comment reminded me of something Sequoia’s Doug Leone said in his interview with Harry Stebbings recently. “It takes about thirty minutes for someone to relax, which is why I refuse to interview someone for thirty minutes.” Similarly, while a 30-minute coffee chat may just be 30 minutes, the time it takes to shake hands, order your cup of coffee, have the conversation, finish it, and walk back to your car or wait for your Uber helps anyone, not just a VC, understand so much more depth to your character.
If you stay ready, you don’t gotta get ready 😎
— Ruben Harris – rub3nharris.eth (@rubenharris) October 13, 2021
As if he didn’t drop enough mics in our lunch, Ratan left me with one last hot take, “In VC, you’re either asked to stay, or you’re asked to leave.” In today’s ever-changing climate, having deep domain expertise and pre-empting diligence keeps you if not ahead, at least on the curve of evolution. And for many investors, it’s one of their best bets to be asked to stay – either by the firm’s senior partners or your LPs.
Thank you Niko and Ratan for looking over earlier drafts.
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I was doomscrolling through Twitter when I stumbled on Samir Kaji‘s recent tweet:
A reason that emerging managers have done so well in early funds is not due to smaller funds sizes but because when gp/thesis is often strongest. Return atrophy usually happens when thesis drift happens at a magnitude that is more significant and faster than firm evolution.
I’ve written before that the difference between an emerged fund manager and an emerging manager is one’s raised a Fund III and the other hasn’t.
In Fund I, you’re selling a promise – a dream – to your LPs. That promise is often for angels, founders, and other GPs who write smaller checks. You’re split testing among various investments, trying to see what works and what doesn’t. More likely than not, you’re taking low to no management fees, and only carry. No reserve ratio either. And any follow-on checks you do via an SPV, with preference to your existing LPs. You’re focused on refining your thesis.
In Fund II, you’re pitching a strategy – the beginnings of pattern recognition of what works and what doesn’t. You’re thesis-driven.
Fund III, as Braughm Ricke says, “you’re selling the returns on Fund I.” On Fund III and up, many fund managers start deviating from their initial thesis – minimally at first. Each subsequent fundraise, which often scales in zeros, is a lagging indicator of your thesis and strategy. And across funds, the thesis becomes more of a guiding principle than the end all, be all of a fund. There are only a few firms out there that continue to exercise extreme fundraising discipline in. Which, to their credit, is often hard to do. ‘Cause if it’s working, your LPs want to put more money into you. And as your fund size scales, so does your strategy.
Subsequently, it becomes a race between the scalability of a fund’s strategy and fund size.
Softbank’s mistake
In 2017, Softbank’s Vision Fund I (SVF I) of $100B was by far the largest in the venture market. In fact, 50 times larger than the largest venture funds at the time. Yet, every time they made a bad bet, the media swarmed on them, calling them out. The reality is that, proportionally speaking, Softbank made as many successful versus unsuccessful bets as the average venture fund out there. To date, SVF I’s portfolio is valued at $146.5 billion, which doesn’t put it in the top quartile, but still performs better than half of the venture funds out there. But bigger numbers warrant more attention. Softbank has since course-corrected, opting to raise a smaller $40B Fund II (which is still massive by venture standards), with smaller checks.
While there are many interpretations of Softbank’s apparent failure with SVF I (while it could be still too early to tell), my take is it was too early for its time. Just like investors ask founders the “why now” question to determine the timing of the market, Softbank missed its “why now” moment.
Bigger funds make sense
I wrote a little over a month ago that we’re in a hype market right now. Startups are getting funded at greater valuations than ever before. Investors seem to have lost pricing discipline. $5 million rounds pre-product honestly scare me. But as Dell Technologies Capital‘s Frank told me, “VCs have been mispricing companies. We anchor ourselves on historical valuations. But these anchors could be wrong.” Most are vastly overvalued, yet future successes are grossly undervalued.
Allocating $152 billion into VC funds, LPs are excited about the market activity and that the timeline on returns are shorter. Namely:
Exits via SPAC,
Accelerated timelines because of the pandemic (i.e. healthcare, fintech, delivery, cloud computing, etc.)
And secondary markets providing liquidity.
We’ve also seen institutional LPs, like pension funds, foundations, and endowments, invest directly into startups.
Moreover, we’re seeing growth and private equity funds investing directly into early-stage startups. To be specific over 50 of them invested in over $1B into private companies in 2021 so far.
As a result of the market motions, the Q2 2021 hit a quarterly record in the number of unicorns minted. According to CB Insights, 136 unicorns just in Q2. And a 491% YoY increase. As Techcrunch’s Alex Wilhelm and Anna Heimputs it, “Global startups raised either as much, or very nearly as much, in the first two quarters of 2021 as they did in all of 2020.”
Hence, we see top-tier venture funds matching the market’s stride, (a) providing opportunity for their LPs to access their deal flow and (b) meeting the startup market’s needs for greater financing rounds. Andreessen recently raised their $400M seed fund. Greylock with their $500M. And most recently, NFX with their $450M pre-seed and seed Fund III.
In his analysis of a16z, writer Dror Poleg shares that “you are guaranteed to lose purchasing power if you keep your money in so-called safe assets, and a handful of extremely successful investments capture most of the available returns. Investors who try to stay safe or even take risks but miss out on the biggest winners end up far behind.” The a16z’s, the Greylocks and the NFXs are betting on that risk.
Fund returners are increasingly harder to come by
As more money is put into the private markets, with startups on higher and higher valuations, unicorns are no longer the sexiest things on the market. A unicorn exit only warrants Greylock with a 2x fund returner. With the best funds all performing at 5x multiples and up, you need a few more unicorn exits. In due course, the 2021 sexiest exits will be decacorns rather than unicorns. Whereas before the standard for a top performing fund was a 2.5%+ unicorn rate, now it’s a 2.5% decacorn rate.
The truth is that in the ever-evolving game of venture capital, there are really only a small handful of companies that really matter. A top-tier investor once told me last year that number was 20. And the goal is an investor is to get in one or some of those 20 companies. ‘Cause those are the fund returners. Take for example, Garry Tan at Initialized Capital, earlier this year. He invested $300K into Coinbase back in 2012. And when they went public, he returned $2B to the fund. That’s 6000x. For a $7M fund, that’s an incredible return! LPs are popping bottles with you. For a half-billion dollar fund, that’s only a 4x. Still good. But as a GP, you’ll need a few more of such wins to make your LPs really happy.
I also know I’m making a lot of assumptions here. Fees and expenses still to be paid back, which lowers overall return. And the fact that for a half-billion dollar seed fund, check sizes are in the millions rather than hundreds of thousands. But I digress.
There is more capital than ever in the markets, but less startups are getting funded. The second quarter of this year has been the biggest for seed stage activity ever, measured by dollars invested. Yet total deal volume went down.
Each of these startups will take a larger percentage of the public attention pie. Yet, most startups will still churn out of the market in the longer run. Some will break even. And some will make back 2-5x of investor’s money. Subsequently, there will still be the same distribution of fund returners for the funds that make it out of the hype market.
In closing
As funds scale as a lagging indicator of today’s market, the discipline to balance strategy and scale becomes ever the more prescient. We will see bigger flops. “Startup raises XX million dollars closes down.” They might get more attention in the near future from media. Similarly, venture capitalists who empirically took supporting cast roles will be “celebretized” in the same way.
The world is moving faster and faster. As Balaji Srinivasan tweeted yesterday:
But as the market itself scales over time, the wider public will get desensitized to dollars raised at the early stages. And possibly to the flops as well. Softbank’s investment in Zume Pizza and Brandless turned heads yesterday, but probably won’t five years from now. It’s still early to tell whether a16z, Greylock, NFX, among a few others’ decisions will generate significant alphas. I imagine these funds will have similar portfolio distributions as their smaller counterparts. The only difference, due to their magnitudes, is that they’re subject to greater scrutiny under the magnifying glass. And will continue to stay that way in the foreseeable future.
Nevertheless, I’m thrilled to see speed and fund size as a forcing function for innovation in the market. There’s been fairly little innovation at the top of the funnel in the venture market since the 1970s. VCs meet with X number of founders per week, go through several meetings, diligence, then invest. But during the pandemic, we’ve seen the digitization of venture dollars, regulations, and new fund structures:
Quoting a good friend of mine, “It’s a good time to be alive.” We live in a world where the lines between risk and the status quo are blurring. Where signal and noise are as well. The only difference is an investor’s ability to maintain discipline at scale. A form of discipline never before required in venture.
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There’s a comical number of debates around where the team slide goes in a pitch deck. In fact, this blogpost may end being more of a meme than have any substantive value. Nevertheless, here’s to hoping that by the end of this essay, there’s some semblance of a call-to-action for you. The “too-long-don’t read” answer for the order of your team slide is… it depends.
Why “why you” is important
First, let’s start from the “facts”.
The earlier your company is, the more your team matters to an investor. The more mature your company is, the less it matters.
If your investor doesn’t understand your answer to the “why you” question, you’re not winning any gold medals, much less a check.
Investors have, effectively, three questions they want answered in the intro meeting.
Why now?
Why this?
And, why you?
“Why now” tells an investor why they should look into the space. “Why this” tells an investor why they should look at the solution. But if we’re being completely honest, if an investor is a specialist and not a generalist, and even if they were the latter, you’re not the first person who’s brought up the exact same “why now” and “why this”. Even if you answer the first two questions perfectly, there’s still no reason as to why you should be the one to take this product to market. Investors, if they were more blunt, would just thank you for your market research.
On the other hand, if you can answer the “why you” question, you give them a reason to have a second conversation with you. And the whole goal of the intro meeting is to have the second meeting. Not to get the check. Don’t skip steps. As a footnote, your mileage will vary with angel investors and micro funds. For them, speed is their competitive advantage, not their check size nor possibly their network or resources. While they will try to be helpful, they’re not a platform – yet. If you answer the “why you”, in the worst case scenario, your investors won’t regret backing the startup. You just weren’t lucky. But they’d probably be willing to back you again if you started another business.
The reason why so many VCs regress back to metrics and traction is because you’ve failed to answer the “why you” question.
Founders haven't sold them on the "why you" so they regress to finding answers for "why this" and "why now", which typically come in the form of lagging indicators like rev and traction
Based on the above “facts”, the younger your startup is, the earlier you should put the team slide. To give investors context as to who you are. This matters a bit more for partnership meetings, as well as if this is a (relatively) cold pitch. That is, to say, if you AND your co-founders don’t have a prior relationship with the people you are pitching to, move the team slide to the beginning.
Eniac Ventures, an incredible seed-stage firm, recently wrote, “We believe that it should probably be slide 1 or 2. That’s because investors want to become familiar with the people behind the product early on, whether we’re flipping through the deck or you’re pitching us directly. When the team slide is second, it also gives you a great opportunity to walk investors through your background and impress upon them why your unique set of experiences makes you and your team the best one to build and scale the product.”
In closing
But, that might not be the case for you. The investors you pitch might have a different set of priorities. I always go back to the question: When going into the meeting, if the investor could only ask one question, what is the one question they need the answer for to give them enough of a reason to take the second meeting?
Then your pitch deck should be in that order of priority.
If you’re tackling a problem most people care little about or where it’s non-obvious, talk about the problem first.
If it’s not a revolutionary product and it already makes sense, talk about why you and your team are the best equipped to tackle this problem.
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In the venture world, there’s this concept of the anti-portfolio. A portfolio for incredible startups you had the chance to invest in, but chose to pass on. Usually the startups that qualify to be in this anti-portfolio have already reached mainstream – either having gone public and/or have reached unicorn status. For anti-portfolio references, I highly recommend checking out Bessemer‘s or tuning into Samir Kaji’s Venture Unlocked podcast, where he asks each guest about their anti-portfolio.
But having chatted with a number of incredible investors, what’s more important than names on an excel sheet is the lesson or lessons we take away from passing on the greats. Those lessons are the very answer to one of the most insightful questions an LP (limited partner) can ask. “How does your anti-portfolio advise your current investment thesis?”
In a similar way, life is a mixed bag of engineered serendipity and endured scar tissue. Our past mistakes inform our future decisions. You learn how to handle kitchen cutlery after cutting yourself a few times. You learn to walk after stumbling. And you learn to communicate after making a fool of yourself. We are a product of the scar tissue we’ve accumulated.
I’m in my first inning in the venture world, and admittedly, way too early to have any true hall-of-famers in my anti-portfolio. So rather than looking into the past from the present, I thought I’d look into the “past” from the future. A “past” that has yet to come, but will be defining of my future. Something Mike Maples Jr calls backcasting. Starting from the future and making my way back to today, along the way, figuring out what I need to do to get to that future. If you’ve been following this blog for a while, you know I’m a big fan of his mental model. “The future doesn’t happen to us; it happens because of us. […] Breakthrough builders are visitors from the future, telling us what’s coming.”
Rather than what startups are in my anti-portfolio, what startups would I love to have in my anti-portfolio?
On a similar note, for non-investors: Ten years from now, what are mistakes you’d want to have made that you tell yourself that it was a decade well-spent?
The DGQ series is a series dedicated to my process of question discovery and execution. When curiosity is the why, DGQ is the how. It’s an inside scoop of what goes on in my noggin’. My hope is that it offers some illumination to you, my readers, so you can tackle the world and build relationships with my best tools at your disposal. It also happens to stand for damn good questions, or dumb and garbled questions. I’ll let you decide which it falls under.
Subscribe to more of my shenaniganery. Warning: Not all of it will be worth the subscription. But hey, it’s free. But even if you don’t, you can always come back at your own pace.
There is an incredible wealth of people in this world who self-proclaim to have insights or secrets to unlocking insights. From parents to teachers to the wise soul who lives down the street. From coaches to gurus to your friendly YouTube ad. To mentors. To investors. While there are a handful who do have incredibly insightful anecdotes, their stories should serve as reference points rather than edicts of the future. Another tool in the toolkit. No advice is unconditionally right nor unconditionally wrong. All are circumstantial.
After all, a friend once told me: All advice is autobiographical.
The same is true for anything I’ve ever written. Including this blogpost in itself.
Over the past two weeks, as a first-time mentor, I’ve had the incredible fortune of working alongside and talking to some amazing founders at Techstars LA. At the same time, I was able to observe some incredible mentors at work. And in this short span of time so far, I’ve gotten to understand something very acutely. The dichotomy between mentors and investors. For the purpose of this blogpost, I’m going to focus on startup mentors, rather than other kinds of mentors (i.e. personal mentors). Although I imagine the two cohorts of mentors are quite synonymous.
While the two categories aren’t mutually exclusive, there are differences. A great mentor can be a great investor, and vice versa. But they start from two fundamentally different mindsets.
Investors/mentors
An investor tries to fit a startup in the mold they’ve prescribed. A mentor fits themselves into the mold a startup prescribes.
An investor thinks “Will this succeed?” A mentor thinks “Assuming this will succeed, how do we get there?”
An investor starts with “Why you?” A mentor starts with “Why not you?”
An investor evaluates how your past will help you get to your future. A mentor helps you in the present to get to your future.
An investor has a fiduciary responsibility to their investors (i.e. LPs). A mentor doesn’t. Or a mentor, at least, has a temporal responsibility to their significant other. Then again, everyone does to the people close to them.
An investor will be on your tail to hold you accountable because they’ve got skin in the game. A mentor might not.
You can’t fire your investor. You can theoretically “fire” your mentor. More likely, you’re going to switch between multiple mentors over the course of your founding journey.
An investor has a variable check size-to-helpfulness ratio. Who knows if this investor will be multiplicatively more helpful with intros, advice, operational know-how than the size of their check? A mentor has theoretically an infinite CS:H ratio. Check size, zero. Helpfulness, the sky’s the limit.
It’s also much harder to find a mentor than an investor, outside of startup communities, like On Deck and Indie Hackers, and acceleration and incubation programs, like Y Combinator and Techstars. Frankly, being a mentor is effectively doing free consultations over an extended period of time. And if you’re outside of these communities, the best way to bring on mentors is to bring them on as advisors with advisor equity. I would use Founder’s Institute’s FAST as a reference point. And Tim Ferriss‘ litmus test for bringing on advisors: If you could only ask 5-10 very specific questions to this person once every quarter, would they still be worth 0.5% of your company without a vesting schedule?
In closing
As I mentioned above, being a mentor and an investor isn’t mutually exclusive. The best investors are often incredible mentors. And some of the greatest mentors end up being investors into your startup as well. Having been in the venture world for a while, I’ve definitely seen all categories on this Venn diagram. Sometimes you need more of one than the other. Sometimes you need both. It’s a fluid cycle. And for the small minority of venture-scalable startups, it’s worth having both.
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Founders often ask me what makes a VC say yes. Or what they need to do for a VC to say yes. Or what they need to do for me to say yes. TL;DR: it depends. On firm, partner, thesis, active conversations, stealth investments, next fund fundraising schedules, reserve ratios, implicit biases, and more. In sum, a million reasons. And even if I knew all the above, I still can’t guarantee a term sheet.
So I can’t say what’ll guarantee a VC yes. A term sheet. If I could, I’d be the one writing them. Nevertheless I do my best to help brilliant founders get funded. On the flip side, here’s what aren’t educated guesses, but guarantees. Or as close as one can get to a guarantee. A guaranteed no. An anti-playbook, if I might call it that. If it doesn’t help, I hope, at the very minimum, it provides you a few minutes of entertainment.
Not treating me as a human. This is less of a reason for me to get myself worked up. There are discriminatory, dismissive, bigoted people in the world. I get it. This is more of a problem for the founder when they’re looking to scale the team. Being a dick limits your ability to grow and/or empathize with the market. If you’re fine with treating me this way, then you’re definitely going to not bat an eyelid with other future hires, team members, investors, and customers. Equally true for any VCs/angels/investors out there.
Badmouthing others. This is more of a personal turnoff. We’re all intellectuals here. And it’s okay to have differing opinions of the world. But it’s not okay to talk behind others back. If you’re gonna badmouth others, I imagine the exact same for anyone else who gets on your bad side for whatever reason, including myself. Practice good social hygiene.
Complaining about your team/product. Complaining is a bit more nuanced. It’s fine from time to time, we’re human. I don’t expect you to be the perfect human, but a first meeting with me, as with any investor, is a first date. I want to hear about the bigger picture, the vision, the dream. Impress me. If you have time to complain during a 30-minute meeting, you’re probably not spending your time wisely. And if this is an intro meeting, you have yet to build up your social rapport with me to complain. Being frustrated about the market is fine. Being honest, introspective, and vulnerable is also fine. Your mileage may differ for the last part, but I love candid founders.
Lying. That goes without saying, if you’re lying about numbers or if I somehow find out that you are, then no. If you don’t know, you don’t know. If your numbers aren’t pretty, admit it. While I might not be able to help you get funded, I’ll do my best to help. If you don’t know something, admit it as well. And find out after. Going back to the earlier point, I love candid founders who have a bias to action.
Having an exit strategy slide. This is more true for larger $100M+ funds I send deals to. Having an exit makes sense for angels, and smaller funds, but larger funds need to look for fund returners and outsized winners, and an exit of XX/XXX million is not sexy at all.
Crazy, but not crazy and reasonable. This one is a new one, inspired by PG. It’s fairly rare, since I try to avoid putting myself in situations with crazy, especially cantankerous people. But it happens. If by any chance, you know your idea might err on the side of crazy, walk me through the logic of how you got there. Don’t just tell me “It makes sense to me” or “I know the industry better than you do.”
Lack of focus. It’s great if you want to do a million things, but saying you want to focus on everything means you’ll end up focusing on nothing. A lack of focus shows a lack of priorities. Focus and be able to back up why are you focusing on this at this point in time. I love Phil Libin‘s 4-year plan defined by one word for each year forward. You can find that plan here and here.
Asking for an intro without any context. “I saw you were connected with X on LinkedIn. Can you introduce us?” If that line pops up in the first 30 seconds of our first conversation, I’m running away. I need to know who you are, what you’re building, why it matters, and hell, why would this person you want to get introduced to is a good use of yours and their time. Build a relationship first. Don’t lead with the transaction. I am not an ATM machine. Neither are other people – investors or not.
Asking me to sign an NDA. Early on in my career, I admittedly signed a number of NDAs sent to me by founders. I love connecting brilliant people together, but if I have to get your permission each time I pass it to an investor or a potential advisor, it’s too much work for me. Frankly, I have other priorities. I get it; I’m a stranger. But I hope you can at least trust that I won’t run away with your idea or give it to a competitor. You have my word. If that isn’t enough for you, that’s fine. I’m just not your guy.
Asking the VC to do their work. “When we raise X dollars, we will do Y tasks.” I usually follow up on that statement with “What have you done so far to accomplish Y?” My least favorite founders are the ones who say something along the lines of, “We’ll worry about that when we get there.” Or “We were hoping our future investors will find someone for us.” We don’t expect you to know everything and everyone, nor do everything right, but we expect you to do some legwork to show you are learning. Show us that you’ve been scrappy, resourceful, and used what you had available to you.
Lack of self-awareness. “Where are you weak at?” If your answer is “Nothing” or “I’m good at everything”, that sends alarm bells to any investor. Which might also lead to a secondary question of “What do you need me for then?” A close cousin is one of my favorites: “What is your competition doing right?” If your answer is also “Nothing”, then you might need to do some market research and reconnaissance again. There’s a reason other customers are using your competitors’ and incumbents’ products. Find it out. On top of what they’re weak at. There’s a romanticized concept in Silicon Valley that every founder needs to be like Jobs with his reality distortion field. While it’s true you need to be able to help others see the future you’re seeing, you also have to deeply understand the realities of today of what’s stopping you from getting there.
Nothing’s changed since the last time we spoke. Investors invest on potential. A bet we make in a company is a bet that it has a chance to be as big as X tech giant in your space. Your ability to meet the demand in the market scales with the number of investment dollars in your company. That said, we expect movement. We expect deltas. And if your product really is inevitable in the market, you should be making progress with or without injections of capital. The latter, just at a slower pace. Venture capital is impatient capital. Also understand, 99% of businesses in the world don’t need VC dollars and operate incredibly well without venture investors.
You’re not obsessed about the product and the market. Building a scalable startup requires obsession. It requires you to lose sleep. You can’t just check out at 5 or 6pm. While I can’t measure that in the first meeting, a close proxy is how well you know the table stakes metrics of your business – net retention, CAC, LTV, growth, revenue, engagement rates – and more. In fact, obsessed founders usually tell me that they’ve already thought of and tried out the first 10 ideas I think of. Moreover they bring me back the results of their discovery. Obsession is contagious.
I have no idea what your product is or does. This is simple. If I walk out of our meeting and I still have no idea how to describe your product to others and why we need it in the world now, there’s no way I can confidently pitch your startup to the partners. Piggybacking off of the #14, if you’re obsessed about the product, you’ve told your story a million times and a million ways already. A few of which should have already resonated with select audiences. And even if it wasn’t to investors, you must’ve already told that same story to your customers. As a CEO/founder, you are the first and most important salesperson. In many ways, it means you have to push the sale. You have to get your customers to take action. I, admittedly, am a potential customer. A recipient of your sales strategy. And if I don’t get your pitch, it’s likely others might not as well. That said, for certain industries, like deep tech or biotech, I’m really, really dumb. So take my thoughts with a grain of salt.
This post was inspired by Jason Lemkin‘s blogpost, which I highly recommend checking out.
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