Category: Venture Capital

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How to Get Investors to Just Ask One Question: “How Can I Invest?”

After recently tuning into an incredible founder’s most recent investor update, I stumbled across a shoutout once again to Silicon Valley storytelling legend Siqi Chen. It wasn’t the first and surely won’t be the last time I find such kudos from a mutual friend. I’ve been a huge fan since his 2019 presentation on presentations, and there’ve been multiple times his name has surfaced in a conversation with friends. I’ve also publicly written about just how amazing he is. That day, I felt the cosmos telling me today was the day. Something just felt right. A swig of that Felix Felicis, if you know what I mean. In hindsight, I guess I could have asked for a warm intro. But my enthusiasm just couldn’t wait.

My question was simple:

“What do you think sets a top 0.1% story from a top 5%er? What sets a timeless story apart from a box office hit?”

“Hm, it’s a good question. Maybe two things: ‘proof of work’. In other words, founder-market fit. Authenticity can be faked so ‘proof of work’, in terms of background, experience, expertise for your authenticity, is valuable. The second thing is just sheer effort, finesse, and practice.”

He ended his answer with a quote you might find quite familiar from his storytelling presentation:

“Magic is just spending more time on a trick that anyone would ever expect to be worth it.” – Penn & Teller

And naturally, I had to follow up. “What are the top 1-2 questions you ask yourself to help you stress test if you’re telling epic stories? Or if it’s more applicable, questions you ask others to see if your story resonated with them?”

To which, he left me with a rather curious statement:

“The stress test for me is when, after the story, there are no questions other than ‘How can I invest?’ This is probably the biggest hack I have for a pitch, which is that contrary to popular belief that questions are an expression of interest, all questions are bad.”

I paused. All. Questions. Are. Bad. To a person who makes a living out of asking questions, you can damn well be sure that whatever I was thinking, whatever I was doing, whatever I was going to say disappeared in a moment’s grace, like a midsummer night’s dream. He already had my attention, but now, he had my curiosity.

He goes on: “The correct way to look at questions is that they are akin to a compiler error in your pitch: It is the tell tale sign of objections politely withheld until you were done talking. It should be your goal to adjust your pitch such that those questions never come up in the first place.”

Needless to say, as all contrarian sayings went, I found Siqi’s words quite provocative. I hadn’t yet come to terms with his permutation of punctuated words strung into sentences. His words, while in plain English, arrived at my ears in a manner that was quite foreign. But the more he elaborated, the more sense it made.

“You know how when a salesperson is trying to sell you something, whether it’s a SaaS product or a set of steak knives, and you don’t want to buy it, but you’re listening politely?” explains Siqi. “You already have an objection and you have already decided to not buy it. And that objection you’re just holding in your head until they’re done talking.

“The first question you ask after they’re done talking is basically that objection. Once you’ve thought about that objection as the listener, you’re no longer paying attention. That objection is all you’re thinking about.

“Here’s a concrete example. Let’s say the first question you think of is ‘it’s a competitive space, how do you think about competition?’

“That means they were thinking about competition for some unknown period of time while you were pitching, probably from the minute you started. And they already decided to not buy.”

His next few words are worth underscoring. If words carried weight, shine, and could be worn on your fourth finger after an elaborate ceremony, this was it. “The way you debug it is by preventing that question in the first place, for example, by inserting a slide at the beginning explaining: ‘This is a really competitive space, but here’s why we’re doing what we’re doing’. Then you defuse the question and it doesn’t come up in the first place.

“A good pitch removes those objects in your head so that you end up buying. One way to improve your pitch is to systematically remove questions until you’re left with just one: ‘How can I invest?’”

In the deck he shared back in 2019, on slide 19, he has another two lines that are equally as powerful and read: “We unconsciously try as hard as we can to fit new facts into existing opinions. Based on existing opinions we make decisions that make us feel good, or the least bad.”

Unfortunately, Siqi’s right.

How often have you brought up a new fact that contradicts with what your mom/dad/grandma/grandpa believes and they respond with “Don’t believe everything you read online?” And then, read a “fact” from an unconfirmed source that affirms their beliefs and they respond with “I told you so?”

Investors, like any other human, are no different. Questions, therefore, are implicit personal opinions reworded explicitly, with the expectation that the facts you bring up fit in their existing mental models. And if the facts don’t match up, “You’re too early for us”. Or as they tell themselves, “The founders have not given us the facts we look for to fit in the frameworks we have.”

Then again, as founders, you may not be looking to fall into a pre-ordained mold. In fact, the most world-shattering businesses never fit into the mold. So neither should you. Steve Jobs famously said:

“Here’s to the crazy ones, the misfits, the rebels, the troublemakers, the round pegs in the square holes… the ones who see things differently — they’re not fond of rules… You can quote them, disagree with them, glorify or vilify them, but the only thing you can’t do is ignore them because they change things… they push the human race forward, and while some may see them as the crazy ones, we see genius, because the ones who are crazy enough to think that they can change the world, are the ones who do.”

So, if you only have facts, stick with the facts that reaffirm an investor’s opinion of a great startup. Admittedly, that can only be true for the top 0.1% of businesses out there. The vast majority of startups don’t have numbers that fit such a high benchmark honed from years of pattern recognition. A benchmark investors have high conviction in. Certainty, one might say. The great writer Charlie Kaufman once said, “Because when you’re certain, you stop being curious. And here’s the one thing I know about the thing you’re certain about. You’re wrong.”

The best thing about this business – about being an investor – is that it keeps people humble. A fact, unfortunately, many investors forget. So stay curious. And tell us a story so compelling we can imagine no other.

Or as Siqi puts it, “The goal of a great presentation is to create emotions that persuade people to take action.” The founders don’t just share their passion. Their passion is contagious. It spreads like a virus. And whoever is infected shares it with the people around them, which if your story is compelling enough, those people share it with their friends. In a vast game of telephone, the more relatable and inspiring your story is, the longer the game of telephone. Facts become stories. Stories become tales. Tales become legends.

The best stories don’t just share facts. They inspire. They weave facts together in a way so compelling that there are no more questions. The world is filled with limitless amounts of data – most of which are seemingly disparate and meaningless. The best storytellers give the chaos of data meaning. They give data purpose.

In reality, you’re not going to get the pitch down in v1. Practice it, especially with people who have a critical eye with words. They don’t have to be investors. Probably not just with your co-founders and team members because they’re biased. They’ll make lapses in judgment because they already understand the problem space well enough. So well, they won’t have realized you skipped steps in your logic. Practice it with writers, lawyers, speechwriters, marketers, influencers, that Redditor that deconstructs every single presidential speech, and video editors, especially those who edit meme videos. Then when you pitch it to investors, the goal is that they don’t withhold objections because they simply don’t have any.

I can’t help but recall a great line by Robert McKee, “At story climax, you must deliver a scene beyond which the audience can imagine no other.” Equally so, by the end of your pitch, you must deliver a solution beyond which the audience can imagine no other.

Photo by Aaron Burden on Unsplash

Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!

Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal or investment advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.

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Cerebral And Guttural Decisions

Earlier this week, Zach Coelius shared his path to running a fund with the On Deck Angels community. And near the end of the session, one of our fellows asked something along the lines of: How do you pick great founders? To which, Zach responded, and I’m paraphrasing: I look for really smart people I want to be around. And every person has something different that makes them smart.

I’ve heard many variations of Zach’s closing comment over the years. “I look for someone I want to work for.” “I look for someone who gets me excited about a space I didn’t I’d get excited about.” “A really sharp individual who teaches me something new almost every time we talk.” The common thread, in all these statements, is that the thing that drives early-stage investors to conviction is not quantitative, but qualitative in nature. Moreover, given that the next Steve Jobs or Elon Musk will look nothing like either of the afore-mentioned, it’s hard to build the search for outliers into a reliable mental model, other than the openness to be amazed.

Fred Wilson wrote a great piece at the beginning of this week about his rationale for investing in Coinbase, Twitter, and Dapper. His title, which sums it all up really well, is: Keeping It Simple. His lesson: “That’s keeping it simple. It doesn’t always work. We get more wrong than we get right. But when we get it right, amazing things can happen.”

Along a similar vein, I jumped on a call with a buddy of mine who’s raising his first fund after having an enviable track record as an angel. On this said call, we talked about how junior investors, the bottom 75% of investors, late-stage investors, and investors that have yet to find their own way to get to conviction, spend more time on the quantitative. A very analytical, repeatable, quantifiable approach. For better or for worse, cerebral. On the flip side, the best early-stage investors out there, by track record of consistent top-notch returns, don’t spend nearly as much time obsessing over the numbers. Or evidence. In fact, before you invest at the A, for most businesses, there really isn’t any hard metric that is going to get you from 50 to 90% conviction.

Even in my own personal journey, when I started off, I found myself sticking to the “tried and true” questions:

  • What are your unit economics?
  • How many customers do you have? How are they using your product?
  • What percent of your customers are coming back to use the product on the second day?
  • What do your retention curves look like?
  • Your monthly growth rate for the past three months?

All of which, you may notice, are quantitative in nature. In fact, this best part of this blog is that you can literally track my thinking over the past few years. I went from writing about metrics (more here, just to name a few) I look for in startups to writing about intuition. In fact, even my attempt to codify intuition is, by definition, using my frontal lobe.

All I need to worry about are moments when a founder teaches me something new that I didn’t know I would love. A simple, but surprisingly rare happenstance. I see a lot of good startup ideas and teams, even some great ones. But it’s rare I meet an “Oh sh*t!” one. Subsequently, that probably also means, at my current stage, I’d make a poor fund manager, since I don’t have enough consistently high-quality deal flow. Consistent, yes. High-quality, in my humble opinion, yes. But consistently high-quality, I’m still too early. At least in the scope of “Oh sh*t!”

One of the greatest sobering facts about venture is that it’s a business that’s designed to keep you humble. Like Fred mentioned, I am wrong way more often than I’m right. And the times I trusted my head over my gut are times I find most regretful. To better illustrate this, let me share an anecdote.

Back in 2018, one of my good friends introduced me to a set of co-founders. Scratch that. Even before they started working on the business idea. And I’m going to abstract the name of the startup. But if you’re a frequent reader of this blog, you’ve probably already seen the trail of cookie crumbs.

I met them for the first time at their beautiful, well-furnished SF apartment with Scandinavian furniture that definitely warranted a pretty price tag. Out of curiosity, I asked how much it cost to live there. And for four bedrooms and three baths, they shared a ridiculously low number. A third of the price I imagined they’d be paying. Then of course, I had to ask how much the furniture cost. “$100, just to ship them over. Otherwise, they’re all free.”

Apparently, they networked their way into a community of office managers. They learned that so many venture-backed startups in the Bay, upon receiving funding, want to look like Airbnb. Founders buy the most expensive furniture – modern layouts, quirky chairs, rustic-looking tables. They also bring the creme de la creme of interior designers to help them set it all up.

But as statistics show, most of these fold every year. When they do, the last thing they want to worry about is their reminder of frivolous spending. As such, office managers end up with so many pieces of high-end furniture they just need to get rid of. Those same pieces of artisanal furniture now sat in these three founders’ living room. And it’s even crazier to know that they weren’t from the Bay. They didn’t have connections coming here, nor jobs lined up initially.

The stories didn’t stop there. In subsequent catchups, I learned of their previous hustles. Each blew my mind more than the last.

When it finally came down to it, and I had the chance to invest, I fell into the comfort of the shackles of borrowed mental models, demand for traction, metrics, the whole nine yards of what made me sound like a really smart, possibly high-browed, VC. And I said no. Today, they’re worth over nine figures, with 8-figure revenue numbers at their last funding round.

I amassed a massive anti-portfolio in my early days trusting my brain over my gut. A brain, like most, was and continues to be incapable of fully understanding the effects of the power law.

To borrow a Pat Grady lesson, any person with a head above two shoulders – in other words, a recurring practitioner of logic and reasoning – is capable of figuring out what’s wrong. But as an early-stage investor, one of the biggest mental hurdles you have to overcome, is spending more time imagining what can go really, really right. And not its counterpart.

As an investor before product-market fit, you invest belief capital, not optimization capital. You’re not putting fuel on the fire. You’re putting faith in a person – in a team – and in an insight.

Photo by Daniel Mingook Kim on Unsplash

Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!

Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal or investment advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.

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When Should You Sell Your Shares As An Investor?

options, comparison, relative selection, when to sell

Recently, I stumbled across a captivating perspective on aphorisms via Tim Ferriss’ 5-Bullet Fridays. The Procrustean Bed. To be fair, before reading it on Tim’s newlsetter, I haven’t even heard of the concept. In one of his newsletters, he cites two incredible sources:

” ‘Something designed to produce conformity by unnatural or violent means. In Greek mythology, Procrustes was a robber who tied his victims to a bed, either stretching or cutting off their legs in order to make them fit it.’ (Source: Oxford Dictionary of English Idioms).

“Nassim Taleb has a related book of aphorisms titled The Bed of Procrustes. He explains the title thusly: ‘Every aphorism here is about a Procrustean bed of sorts—we humans, facing limits of knowledge, and things we do not observe, the unseen and the unknown, resolve tension by squeezing life and the world into crisp commoditized ideas, reductive categories, specific vocabularies, and prepackaged narratives, which, on the occasion, has explosive consequences.’ “

Down the investing rabbithole

There exist a number of aphorisms in the investing world. Chief of which reads “buy low, sell high.” Public market assets are quite liquid. Hypothetically, you can cash out whenever you want. Such liquidity has paved way for psychological inconsistencies to maximize gratification. In language with unnecessary jargon redacted, the option to sell is less motivated by rational thinking but more by fear of losing money – loss aversion. If you invest $100 into the public market, you can choose if you want to cash out at $95, $90, or $120 or $200. While there is a non-zero chance of you losing your entire principal, chances are you’ll liquidate your positions before that happens.

On the other hand, private market investments are illiquid. Upon investment, there is no liquid market in which you can sell immediately. At best, you have to wait 3-5 years before a rapidly marked-up investment creates opportunities for distributions in the secondary market. In other words, cash money while companies are still private. In the private markets, your principal either appreciates in multiples, rather than percentages, or bottoms out. Any in-betweens will neither make or break your investment strategy, and are often out of your immediate control. So in this case, illiquidity is a feature, not a bug.

The notion of exiting positions as a private market investor, therefore, gravitates towards a singularity – when you make a damn good investment. The only time you really have an option to choose whether you can sell or not, when otherwise, it becomes a tax write-off or a small exit outside of your immediate control.

When should you sell?

Should you ever sell?

And if you sell, how much should you sell?

To answer all the above questions…

With the help of Shawn and Ratan, I wrote a blogpost on how to think about exiting positions at the beginning of this year. A topic of which I am still very much a rookie at, which may be quite apparent in this essay as well. Nevertheless I’m going to try to elaborate more on the notion of selling positions as an early-stage investor.

In a memo earlier this year, Howard Marks wrote that there are two main reasons people choose to sell: “because they’re up and because they’re down.”

When “they’re down”

Let’s start with the latter. When “they’re down.” Like I mentioned before, there are often very few options to sell when things are down. While I’m not proud that these investors exist in the early-stage private markets, I’ve seen and heard of some investors who try to make a last ditch effort to regain some of their principal when the startup goes south. Selling off IP. As well as assets. Or forcing the founders to make a modest exit, so that the investors cap their downside. Maybe at best, this returns them 2x on their capital (rarely the case).

But let’s say that’s the “best” case scenario. And let’s say it’s a $25M Fund I, writing $250K checks. A 2x net return means they got back $750K. $750K is far from returning the $25M fund. Not even close to doing so. You need over 30 of those “exits” to just break even for your fund. So, if you’re an investor penny pinching here, you’re in the wrong game AND you’re going to lose out on the relationships with the founding team.

Why the wrong game?

Venture is a hit-driven business. It’s not about your batting average but about the magnitude of the home runs you hit. We bat for 100x returns, which also increases the probability of misses, determined by ability to return the fund or not. If you’re optimizing for local maximums, you’d probably do better as a public market investor.

And why do relationships matter?

One, the startup world is a smaller world than you think. People gossip.

Two, statistically, first swings at bat rarely work out. In research done by Cowboy Ventures, they found 80% of unicorns had at least one co-founder with previous founding experience. Paris Innovation Review also found that “86% started their project with a partner, after having created other companies.” Two of many other studies. So, even though this venture didn’t achieve financial success for an investor, the next might. Or the one after that. Assuming you bet on the right people, it’ll just take a couple iterations before timing, market, and product also match up. If you leave on bad terms on this deal, you won’t be able to get in when things do work out.

Three, what makes early-stage investing incredible is the relationships you build along the way. The ability to learn and grow with really smart people.

When “they’re up”

The question of if to sell often leads to controversial debate. I know of some investors who never sell any of their stock. And that if they sell, to them, it is a measure of their lack of faith in a founder. And they would never want to feel that they’re betting against the founders. That’s okay if you’re an angel. But if you’re a VC, you have a fiduciary responsibility to your investors, which means you’ll eventually have to sell.

The question of when to sell is often answered in broad strokes with laws around QSBS, which states that if you hold a qualified small business stock for longer than five years, you’re not subject to capital gains taxes in the US. But should you sell in the 6th year or 10th year? And under what market conditions? Do you sell in a boom market or on the precipice of a bust market? For a company you believe in the long-term potential, regardless of short-term fluctuations, I’m a big fan of what Bill Miller said in his Q3 2021 Market Letter. “We believe time, not timing, is the key to building wealth in the [market].”

But when things are going really, really, really well, it’s okay to take money off the table, even ahead of the end of the fund’s 10-year lifespan. In fact, Union Square Ventures generally sells 15-30% of their position in their top portfolio companies to distribute back to their LPs. Fred Wilson‘s personal framework lies around “[selling] one third of the position immediately, put one third away for a long term hold, and actively manage the other third.”

To most, including myself, the goalposts for selling how much seem arbitrary. USV sold 30% of their position in Twitter to return twice the entire fund. Menlo Ventures sold almost half of their stake in Uber when Softbank offered to buy. Whereas, Benchmark sold 15% of its Uber shares. I also have really smart friends who liquidate 50% of their stake in a token if a single cryptocurrency reaches double digit percentages of their net worth.

It’s all about the opportunity cost

In a game where arbitrage matters, and the “why” matter more than the “what”, it was love at first sight when Howard Marks shared his mental model on selling. He boils it down to the simple economic concept of opportunity cost:

  1. “If your investment thesis seems less valid than it did previously and/or the probability that it will prove accurate has declined, selling some or all of the holding is probably appropriate.
  2. “Likewise, if another investment comes along that appears to have more promise – to offer a superior risk-adjusted prospective return – it’s reasonable to reduce or eliminate existing holdings to make room for it.”

In sum, the option to sell is not an isolated decision, but rather one which considers the other investment opportunities you have available to you. For a number of VCs, this breaks into the calculus of recycling carry and what to use early distributions to invest in next. If you’re a VC with consistent AND high-quality deal flow, you’d probably want to reinvest. If you’re a VC without either of the two (i.e. only consistency or quality) or an emerging angel, your goal is to get both. In having both, you then have access to relative selection.

Photo by Sina Asgari on Unsplash

Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!

Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal or investment advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.

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What Does Signal Mean For An Early-Stage Investor?

signal, lighthouse

When winds and waves a mutual contest wage,
These foaming anger, those impelling rage;
Thy blissful light can cheer the dismal gloom,
And foster hopes beyond a wat’ry doom.

– John William Smith, “The Lighthouse,” 1814

Marc Andreessen answered a few weeks back to a question that has been ringing in many founders’ minds. What product do founders want to buy from investors? For the past few years, the natural answer rose as operational expertise. A notion that still holds true for the earliest stages of starting a business when you bring on strategic angels as small checks to help you find product-market fit. As you continue down the path and start raising institutional capital, the answer becomes more and more amorphous.

On a similar note, Bryce Roberts the exact same question last year:

To which, he responded:

Why do investors look for signal in the first place? A means to de-risk a very early, and very risky bet. A product of asymmetric information. Investors invest in lines not dots, but the truth is, most investors don’t have the time – luxury or ability – to see all lines. So what they must do instead is look for specific dots – be it traction, co-investors, or founding team “legitimacy” – that would help them trace out of a line of best fit. As Precursor’s Charles Hudson wrote earlier this week,

By definition, signal should be a leading indicator of long-term business value. Yet, for most investors in the world, what they look for are lagging indicators of conviction.

The signal paradox

In the investing world, there’s a paradoxical notion of signal. Through many conversations with syndicate leads, data teams of investing platforms, and LPs, I realized a common thread. For the majority of investors in the world, at the early stages, signal comes not from the founder, but from other funders.

In a syndicate, there are three things that make a deal move fast:

  1. Great co-investors
  2. Great traction
  3. And, great team

Arguably in that order. Synonymously, as an emerging fund manager, the best way to raise from family offices* (I’ll explain below why FO’s are my reference point here) who are notoriously closed off to cold emails, you need:

  1. Tier 1 VCs as your co-investors
  2. Tier 1 GPs as your fund’s LPs
  3. Or, deals that family offices wanted to get into anyway (which isn’t mutually exclusive from the above as well)

Quite noticeably, for many investors out there, signal comes in the form of people with a proven track record already. Or to break it down even more. Signal comes in the form of familiarity. Familiarity in the form of warm intros or college classmates or pattern recognition. The easiest pattern to follow for any investor without needing to do too much diligence or requiring too much personal conviction (I know, it’s funny), but to be able to write fast checks, is other top-tier investors. If you’re a founder who’ve fundraised before, you’re probably very familiar with this notion. Consciously or subconsciously. I’m gonna bet money that you’ve been asked, “Which other investors are you talking to? And how far along the process are you with them?” Or simply, “Do you have a lead investor?”

While there are some nuances to the last question, like the inability for smaller investors to pay for legal counsel fees, to have the resources to completely diligence a startup, or just that the check size required to lead/fill the round is just too large for them, generally speaking, my argument still stands. Put nicely, for many investors, they’re looking for external validation of the product. Put harshly, that question is a band-aid approach to their inability to get to conviction.

As a founder, you have to realize that capital has become a commodity. Investors are in the business of selling money. And subsequently, making $1 become $2. Or for a great early-stage investor, $1 becomes $5. There are many ways to underwrite risk. The one that requires the least amount of new thinking, or thought leadership, is following firms who have proven their investing acumen already and consistently.

*Additional context on family offices

I specifically mention family offices above since most LPs in Fund I’s are individuals and angels. Mostly small checks. And can quickly fill up the limit the SEC has set for how many accredited investors you can have investing in your fund. And their reason to invest is based on the founding GPs – very similar to why investors would back startups at the pre-seed stage.

While some GPs do pitch to institutional LPs (i.e. endowments, pension funds, fund of funds, etc.), very, very little institutional capital goes to Fund I’s and II’s – very similar to the fact that Tiger or Coatue very rarely invest before the A. You have yet to have a track record where they can fit into their financial model. They’re underwriting a very different type of risk. And so, if you’re a Fund I GP looking for larger checks, you’re looking to generational wealth in the form of family offices, who are surprisingly closed off to cold emails. But I digress.

The surplus of “signal” in 2021

In the last year, we’ve seen some record-breaking numbers. We’ve been in an exciting boom market. There have never been more venture dollars poured into the ecosystem. In fact, there were 1,148 concurrent unicorns in 2021. Half of which were new. In comparison, 2020 minted just 167 unicorns. Just looking at the two charts from Crunchbase below, we see just how crazy 2021 was.

Source: Crunchbase
Source: Crunchbase

And quite reflectively, there have never been as many “experts” in the market. To be fair, when everyone’s portfolio and/or startup is raising consecutive rounds of funding and mark ups are a dime a dozen, psychologically, I would also feel good about myself too. Everyone’s an “expert” in a boom market, especially if a16z or Tiger is leading the round. And a16z’s done double the number of deals they did in 2020. And Tiger’s invested 4 out of every 5 business days. In full disclosure, I did feel quite proud of myself as well. Nevertheless, I do my best to stay humble in this business.

Interestingly enough, while there were more seed, pre-seed and angel dollars going into startups, progressively, less startups were getting funded. Effectively, while the overall number of dollars invested look great, less founders come to bat. A smaller top of funnel means a more concentrated funnel in consecutive rounds.

Source: Crunchbase

The truth is fundraising will get harder over the next year and valuations won’t be as high. You can expect the current market correction in the public markets to soon be reflected in the private ones. So you may need to spend 12 months longer growing into your next round’s target valuation.

So where should investors look for signal?

In fairness, I am ill-equipped to answer this question for the masses. And most likely will never be fully equipped to make generalist statements. That said, I have and will continue to share what signal looks like for me. And if you’re a founder, here’s my template to conviction.

Two weeks ago, I broke down my sense of intuition around startup investing. I won’t go too deep in this essay, but I do share a more detailed internal calculus there. To put it simply, I look for different signals across the spectrum of idea plausibility and stages.

Signal by idea plausibility

Idea PlausibilityKey QuestionContext
PlausibleWhy 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.
PossibleWhy 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.
PreposterousWhy 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.

Signals by stage

Stage of investmentKey QuestionContext
Pre-seedWhy you?The earlier you go, the less quantitative data you have to support your bet. And therefore, your bet is largely on the founder. For me, it matters less their XX years of experience, but more so their expertise. In other words, insight. Can I learn something new in my first meeting (and consecutive ones too) with them?

At the pre-seed, there is also one more key signal I look for in founders – their level of focus. Rather than wanting to do everything, can they streamline their resources to tackle one thing? What is their minimum viable assumption they have to prove before they can build their MVP (or MLP – minimum lovable product)? Startups often die of indigestion, not starvation.
SeedWhy now?By the seed stage these days, you’ve either found your product-market fit or really close to finding it. The larger your round, the more you’re feeling the pull of the market. Whereas pull can come be measured (i.e. daily organic sign ups, demand converting to supply in a marketplace, etc.), sometimes when you’re at the cusp of it, there’s a level of foresight that is required. Some leading indicator for the business often comes as a lagging indicator from industry trends. What is the inflection point(s) (political, socio-economic, technological, cultural) we are at today that is going to have compounding effects on the business?
Series AWhy this?By the time you get to the A, you’re ready to scale. In other words, what you mainly need is to add fuel to the fire. I place a larger emphasis on traction here. Admittedly for me, compared to the two earlier stages, this is more of a numbers conversation. The best founders here have a very clear picture of what worked and didn’t work for the business. They’re already familiar with their main GTM channel, but are exploring new opportunities for channel-market fit where they need capital to test.

Not incredibly pertinent yet, but founders will have started thinking about their Act II. What’s the next product they’re going to offer to secure their immortality in the market?

In closing

A simple litmus test I often share with founders on signal is:

Your ability to raise capital is directly correlated with your ability to inspire confidence in your investor that you will get straight A’s with little to no help.

This isn’t just true for myself, but also most investors out there. While the best investors out there will always be there for you in your time of need, before they decide to jump aboard the same ship with you, you need to convince them that you’re a top 10% founder. Or a top 1% in-the-making.

While I dislike using the dating analogy, it’s an apt comparison in this case. You’re not going to share your deepest, least desirable secrets on your first date. You’re also not going around saying you’re the perfect – and I underscore perfect – partner without any flaws. ‘Cause that’s as much baloney as an unknown African prince in your inbox telling you to help him secure $5 million in gold bars by helping him set up a Swiss bank account with a deposit of $10K. It’s too good to be true. In reality, you’re most likely going to share that you have a number of great qualities, but you’re still growing in many ways.

Admit what you don’t know or don’t have. As long as it’s not mission critical or the biggest risk in your business (and if it is, figure that out before you raise VC funding), the investors who truly believe in you will understand. Always err on the side of honesty, but not bravado.

‘Cause you yourself are a signal. If you’ve got your bases covered and still have to go out of your way to convince an investor or try to flip their “no”, they’re probably not worth your time.

Cover photo by Michael Denning on Unsplash

Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!

Any views expressed on this blog are mine and mine alone. They are not a representation of values held by On Deck, DECODE, or any other entity I am or have been associated with. They are for informational and entertainment purposes only. None of this is legal or investment advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.

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How to Develop Intuition as a Rookie Startup Investor

intuition, how to develop intuition

In the month before I started this blog in 2019, I had written 20 odd blogposts as a safety net in case I ran out of ideas in my weekly cadence. Most of which never had the chance to stand in the limelight, including my first one on intuition. Particularly, my one on intuition. Over the years, I’ve honed my own “intuition” – if I may be bold enough to call it that – on vetting startups. My intuition today is very different beast from my intuition 2.5 years back. This essay is a product of such constantly evolving self-discovery.

The spark of my intuition

When I first started my career in VC at Berkeley’s SkyDeck, I reached out to about 70-80 investors for a coffee chat, in which I posed one of my now favorite questions. What is the difference between a good and a great VC? Unsurprisingly, but frustratingly enough, most of the answers came in the form of “intuition.” Or its cousin, “pattern recognition.”

To me, who was still so new to venture, that was the best and worst non-answer I could get. Yet despite knowing that there was truth in their answer, I was still directionless. It wasn’t until an afternoon walk through San Francisco’s South Park with a very generous, but curt gentleman who carried quite the luggage beneath both of his eyes that I got the answer I wasn’t looking for.

“See a shitload of startups. When you see 10, pick your top 2. Then see 100, pick your top 2. Then see 1000, and again, pick your top 2. You’re going to notice that your podium will look quite different the more founders you meet with and the more startups you see.”

Recently, Plexo‘s Lo Toney told our fellows at DECODE the exact same thing:

And so, in hopes to guide someone in my shoes when I first started, here’s how I think about building intuition. Of course, I am a human and will always be a work in progress. It’s likely that next year I will see things differently than I see them today. Nevertheless this essay is a record of my thoughts today in early 2022.

Where to find a “shitload” of startups

There are multiple avenues these days for deal flow, including, but not limited to:

When I first jumped into venture, I used to ask my friends who I knew were early adopters (a product of going to a school in the Bay Area, like Berkeley) of products to recommend me 3-5 startups/products every other week. When they did, I would treat them out to boba. And if they introduced me to the founders for those products that I’d be excited to talk to, I’d treat my friends out to a small meal – around $10-15. At the same time, at SkyDeck, I tried to sit in on as many meetings as I could, particularly the ones around deal evaluation at the beginning of every cohort.

While I do recommend all of the above, the best training grounds for developing intuition is when you talk to founders yourself.

The five senses

Google defines intuition as “the ability to understand something immediately, without the need for conscious reasoning.”

Source: Google

So, by definition, intuition is subconscious – built upon the brain’s natural ability to recognize patterns. An apt synonym, according to the trillion-plus dollar company… “sixth sense.” A sixth sense birthed from the intense neural processing of the five other senses. So, it was only logical for me to understand the sixth sense by first fully comprehending my five others. That said, I use the five-sense nomenclature loosely, but it nevertheless has become my guiding framework for venture decisions over the years.

Smell

“I invested based on my sense of smell.” These are the very words Softbank’s Masayoshi Son shared about his early investment in Alibaba. And he said the same about his investment into Yahoo! In fairness, his words make for good PR. And may just seem like smokes and mirrors. But for Son to have chosen Jack Ma out of the 20 prospective Chinese entrepreneurs he met with to invest in, he must be onto something.

There are two ways to develop an acute sense of smell as an investor, which you can develop in tandem.

  1. Spending a lot of time looking into the market
  2. Talking to many founders

On the former, we’ve been seeing a number of funds incubate their own startup ideas as a result of investors becoming deep subject-matter experts, but are discontent with the current ideas or teams on the market right now. Two examples include General Catalyst and Founders Fund. Draw market maps. Write research reports. Follow the experts on socials or on their blogs. Even better, talk to them as well. As a general warning, it’s hard being a generalist here. I would pick a few industries and/or functions you’re excited about or knowledgeable in already. Go deep before you go wide.

A few questions that have served me well include:

  1. What kind of inflection points are we at in the market? In what areas have headwinds become tailwinds?
  2. What are the technological, political, and/or socio-economic trends to be aware of right now? And where do these trends set up the world tomorrow to be?
    • I really encourage investors here to dream a little bit. To envision a world given these trends in which you’d be excited to have future generations live in.

On the latter, while Masayoshi talked to only 20, you can assume you he went through at least ten times that number of decks and business ideas. There’s no better practice than being in the field. Assuming you’ve taken step one (i.e. researching the market), one of the best litmus tests I’ve used to gauge a founder is their ability to riff on adjacent subjects to the business with me. Are they capable of going on tangents that really demonstrate domain expertise? Or are they caught up in the myopia of just their business?

Taste

There’s two kinds of tastes in which I look for, almost subconsciously, now.

  1. Have they tasted excellence?
  2. Have they tasted blood?

On excellence, many investors out there look for prior success in the field. For instance, previously founder of a unicorn exit, early employee or key executive at a now-successful company, or former big-time investor. Admittedly, there are only a small handful of these individuals out there. But I knew in my early days of scouting, I was at a massive disadvantage here for two major reasons.

  1. I didn’t have strong connections with most of this subset of the entrepreneurial market.
  2. This was also a founder persona I didn’t have unique insight to. In fact, it was general consensus to always take first meetings with these individuals in the venture industry. And as I learned early in my venture career, you make money either if you’re right on consensus or right on non-consensus. The latter of which is counted in multiples instead of percentages, which I’ve written about here and here.

In knowing so, I look for excellence, period. Have they tasted earned glory in any discipline? Do they know what it’s like to succeed in their field? And do they know what it takes to get there? On the flip side, do they know how hard it was to get there?

On the other hand, for blood, I want to know a founder’s propensity for conflict resolution. When was the last time they fundamentally disagreed with their co-founders? And how did they resolve it? Conflicts are inevitable. They’re bound to arise when you’re putting so much at stake for a common goal. I care less about the fact that they do come up, but more about that when they do, the team doesn’t just fall apart.

Every once in a while, I might disagree with the founder as well. And hear I look for the founder’s knee-jerk reaction and their ability to engage in thoughtful discussion. That does not mean they cannot disagree. Neither am I looking for another yes-person. But are they capable of helping me, and themselves, explore new horizons? Are they open-minded enough to entertain new possibilities, but still hold a remarkable level of focus to their 12-month horizon?

Touch

How high-touch or low-touch is this business? How much legwork does an investor need to do for this business to 10x its KPIs (within the next 12 months)?

For me, during my first meeting with the founder, ideally before, I try to answer two very simple questions:

  1. What is the biggest risk of this business?
  2. And is the person who can solve this risk on the team slide/in the room?

99% of the time, the person who can solve the biggest risk of the business has to be in the room. For instance, if it’s a machine-learning (ML) product, it’s a technical risk. So at least one of the co-founders must be a technical genius, not three MBAs. If it’s a B2B SaaS product, it’s a distribution risk. Meaning someone on the team must have deep connections to key decision makers to their target customers. In the early days, that’s really just at least one to two big-name customers. And ten other referenceable businesses. The second biggest risk is sales, and that I count on the founders’ ability to hustle.

1% of the time, and this is probably an exaggeration, you just have to really believe in the founder AND the product or market.

Hearing

Do founders spend more time talking, or more importantly, listening to their customers than they do in Rapunzel’s tower?

While I don’t ask all of them (since we’re guaranteed to run out of time before we run out of topics), here are the questions I consider when assessing how boots-on-the-ground a founder is:

What are customers saying about their product? The good? And the bad?

How did they acquire their first users/customers outside of their existing first degree network? Where from? What messaging do they use?

What is their customer win rate? In knowing so, what worked and what didn’t? At what point in the onboarding process do customers churn? What are their assumptions for why churn happens?

Do they know the numbers of their business (and ideally the market) like the back of their hand? For numbers of the market, are they able to recall the sources of most important numbers? For product metrics, how well do they know the main ones, like engagement, churn, monthly growth rates (over the past 3 months), net retention, and so on? Every so often, there’s a number or two, the founders are not aware of. And it’s fine. The test is once they realize their blind spot, how quickly do they move to patch it up? Subsequently, report back to me about their updated data measurements.

Of course, my job is not to distract founders. And I really try my best not to, so I don’t ask they measure superfluous metrics, unless I really do believe they’re crucial to the business.

Because I usually talk with founders who are pre-product-market fit, I usually lead with the question, “what does product-market fit look like to you?” Are they able to arrive at an actionable and measurable metric to optimize for? And can they back up why that metric is a good proxy for product-market fit?

(In)Sight

Can this founder teach me something new? Something that I never thought of or heard before, but makes complete sense. Is it a preposterous idea but backed by logic? Or does the founder have an original (and money-making) angle to what is already unoriginal? As an investor, especially as you see more startup ideas, the latter question is likely to surface more than the former.

Once the original insight is uncovered, it is then up to me to figure out the potential energy of the insight. How far can this insight take this team? Is it likely that this insight will uncover more insights down the road?

As an investor, you want to be right on the insight and team, not one or the other. Mike Maples Jr. articulates it best when he said, “We realize, oh no, this team doesn’t have the stuff to bend the arc of the present to that different future. Because I like to say, it’s not enough. […] I’d say that’s the first mistake we’ve made is we were right about the insight, but we were wrong about the team.”

“I’d say the reverse mistake we’ve made is the team just seems awesome, and we just can’t look past the fact that they didn’t articulate good inflections, and they can’t articulate a radically different future. They end up executing to a local maximum, and we have an okay, but not great outcome.”

In closing

Seedscout’s Mat Sherman wrote a great Twitter thread last month to help founders who are outsiders raise venture funding.

The fact of the matter is that despite the venture industry being a rather well-connected circle of individuals and firms, most entrepreneurs – both currently and aspiring – are outsiders. If you can’t hit up a close friend to write you a couple million dollars, you’re an outsider. This essay, while written for new investors, hopefully, is equally useful as a guide for founders looking for some insight as to how investors think. Or at the very minimum, how I think.

Photo by Liam Shaw on Unsplash

Any thoughts here are mine and mine alone. They are for informational and entertainment purposes only. None of this is legal or investment advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.

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How Do Investors Think About Early Dilution On The Cap Table?

dilution water investment

A founder recently asked me how investors would perceive her going through two different accelerator programs. Specifically, what would investors think if she took dilutive capital from two investors who care about ownership targets, yet have similar, if not the same, value adds to her business?

How each type of investor thinks about dilution

It’s a great question. Unsurprisingly, a nuanced one as well.

Honestly, a “messy” cap table or early dilution is an excuse investors give when they’re not sold on you or the business. Investors regress to the “why this”, or otherwise known as, traction, when you haven’t convinced them on “why you.”

Investors want to be excited about you. They want to brag about you to their partnership, colleagues and friends. But if you don’t give them a strong reason to, they’re going to regress to what they know will return them capital. Predictability. And that comes in the form of traction. But I digress.

If Max Levchin or Phil Libin or Elon Musk or Justin Kan – pick your favorite serial entrepreneur with unicorn exits under their belt – wanted to raise for a new startup, no matter what it is or how early, people are gonna jump on the opportunity to regardless of how saturated the cap table is.

Let’s stand in the shoes of an investor for a second. Of which there are three main kinds of early investors.

  1. Angels
  2. Non-lead VCs and syndicate leads
  3. VCs who lead rounds

For individual angels, ownership targets don’t matter. They just want a piece of the action. In fact, multiple sources of signal and validation give them more confidence to invest. Especially if you’ve taken previous or current checks from your small handful of top tier VCs. These angels’ check sizes are negligible on the cap table, so they won’t end up crowding anyone else out.

On the other hand, notice how I bucketed non-lead VCs and syndicate leads into the same category. Why? These investors are writing bigger checks. They won’t price the round. And they move a lot faster if someone with a great track record is leading the round. Once again, ownership also doesn’t matter, but great co-investors do. As long as ownership targets don’t matter, the excuse of dilution is merely lip service. The story here is “I just need to get in the best deals, so I can raise my next fund from LPs.” Or “I need build my track record as an investor, so I can raise a fund one day.” I’m going to generalize here really quickly. While it doesn’t apply to every non-lead investor, it does apply to the vast majority. I dare say, 90% of them. These investors move on the combination of three levers:

  1. Great traction
  2. Great team,
  3. And great co-investors – the last of which is often the most important.

The more of the above levers you have as a founder, the faster you’ll get a check from the above individuals and institutions. Why do great co-investors matter so much? Outside of branding and social rapport, their investors – their LPs – also want to invest in these top deals led by these funds, but often can’t invest into these top-tier funds since everyone wants to get into a16z or Sequoia. In fact, for many of these top-tier funds, there’s a massive waitlist of LPs.

Finally, lead VCs. Ownership does matter. Really, this is the only audience you need to worry about when it comes to the topic of early dilution. While you as a founder should be dilution-preserving, sometimes, taking the capital (and subsequently, the dilution) is the best option. Maybe you really need something from an accelerator or an early investor that would be hard to get for you yourself. At that point, their capital becomes optimization capital. Early checks can get you from A to B faster, with less burn potentially, and with less detours.

So, the question you have to figure out if you take subsequent capital injections is that each time you dilute the cap table, did you reach an important milestone? What’s worrying is if you keep diluting your cap table without making meaningful progress each time. Think in the framework of milestone-based financing. Raise what you need, while giving you and your team an appropriate margin of error.

In closing

As a footnote, it’s also important to consider how much equity you as the founder will have left upon exit. If you’re going through large amounts of early dilution, you’re going to have very little upside unless you go through a massive exit. Unlike investors who invest in many businesses and have diversified their risk appetite, you, the founder, have put all your eggs in one basket. So if you care about the upside, you want to reduce dilution unless there is an absolute necessity to raise capital.

Photo by Lucas Benjamin on Unsplash

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No One Talks About Selling

Seemingly, everyone these days – from Twitter to podcasts to blogposts (including mine) – talk about buying and investing in startups. What are best practices for investment theses? How do I pick the best companies to invest in? Conversely, how do I get picked or get allocation into hot startups? But people rarely seem to be talking about selling positions. So, if you know me, I hit up two of the smartest people I know – one early-stage, the other growth-stage. Both of whom might be familiar faces on this blog. So I asked them:

How do you think about selling a position? How much does DPI matter for your investors?

The below insights include minor edits for clarity.

The notice that you’ve all seen a million times

None of this is investment advice. This content is for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Please consult your own adviser before making any investments.

Shawn Merani (Parade Ventures)

Shawn was instrumental in my early career growth in venture. When I met him years ago, he was still running Flight Ventures, where he wrote early checks into Dollar Shave Club and Cruise Automation and was one of the first syndicates on AngelList. There he led a network-based model of syndicate leads, which I’ve heard been described by others as a “venture partner program on steroids.” Now he’s the solo GP at Parade Ventures, a seed stage venture fund investing in enterprise-themed companies.

“I would preface all of this with the fact we have never fully exited a position before a traditional liquidity event, but more so, have managed our position given the duration of our ownership and to generate returns for our LPs and manage risk. 

“We talk to founders all the time, and foster a relationship that grows. When I was writing check sizes for 1-5% of ownership, my engagement then is very different from my engagement with founders now, where we take more concentrated bets.

“When it comes to selling, it’s about influence and information. The larger our ownership, the more information we have access to. And if a company is doing well, we don’t think about selling. In fact, it’s the exact opposite; we buy more. If things are working, we take our pro rata. In some cases, we take more than my ownership target. And founders are willing since we’ve been helping them from the beginning. We know when there’s going to be a 3-4x uptick every 12-18 months. Compounding is powerful.

“Our investors back the fund because they trust us. They don’t talk to the founders as often as we do. They trust our decision when we say we should buy more or keep our shares. There are two ways to talk about DPI:

1. Making money for your current investors, and
2. Telling the story.

“Selling is really a case-by-case scenario, and it really depends on my relationship with the founder. All the equity in which I sold so far has been before Parade. But if we know the company is doing well, we buy more. There are also holding periods to consider under QSBS, which has huge tax benefits.”

For those that are unfamiliar with the terminology, DPI means distributions to paid-in capital. Effectively, how much money you actually return to your investors versus “paper returns”. QSBS, or qualified small business stock, tax exemption allows investors in qualified businesses to avoid 100% of the capital gains tax incurred if they hold their stock for more than 5 years.

Ratan Singh (Fort Ross Ventures)

I posed the same question to someone I’ve been a huge fan of the day I met him – Ratan Singh, Partner at Fort Ross Ventures. He’s an investor in some of the most recognizable businesses today, including the likes of Rescale and Clearcover, as well as holds board seats at Blueshift and Ridecell. You may remember Ratan from a previous essay about speed as a competitive advantage for investors. And you’ll likely see him a lot more on this blog. He summed it up best in our chat when he said, “There are two reasons why an investor needs to care about DPI: time horizon and fund strategy.” Both of which are variables, not constants, between early- and growth-stage investments.

“The true metric at the end of the day is DPI. DPI is turning in money to your investors. And there are two reasons why an investor needs to care about DPI: time horizon and fund strategy.

“Let’s start with time horizon. For a seed stage fund, as you get close to the end of your fund cycle, that’s when DPI matters. What type of vintage is the fund in? In 2021, it’s going to be the 2010 and 2011 funds.

“For the majority of the time, you want to ride your winners. At the end of your time horizon, ask for a one- to two-year extension. Usually LPs want more money or their shares distributed. They’ve already waited 10 years. Two more won’t make a difference, especially if you have some big fund returners in the making.

“For fund strategy, did you meet the objectives for your LPs already? If you have, and you want to sell some of your winnable deals in your portfolio to help raise your Fund II because those are the same LPs that would re-up in your next fund, then you might consider selling.

“The worst reason to sell is that you want to take the wins you currently have since you think the market is overvalued. ‘I’m at the peak.’ Or ‘I want to take chips off the table because there’s something bad that will happen, but that is very hard to predict.’

“There were a bunch of funds at the beginning of this year that sold their entire positions. They were desperate to lock in a win. They sold because they thought the market was at the top. And, they were wrong. I’m against it. Selling early doesn’t fully realize the strategy you have put forth. For us, at the growth stage, we shoot for 48 months to an exit. If it takes longer, did we underwrite it wrong? But even if it does, the case may be that the company is growing a little slower than expected.

“At the early stage, all funds will say 2 to 3x cash-on-cash in the LP presentation. Most funds return 1 to 1.5x, on average, with most funds total DPI at 1.2 to 1.5x, which barely returns the fund. Before your time horizon, everyone likes to cite unrealized gains and mark ups because TVPI’s all they have.

“DPI matters most for funds in the top quartile – the top returners, funds with more than $500 million, or nowadays, $1 billion mega-funds. For the bottom majority of funds, early DPI won’t matter. They would be limiting their upside.

venture returns
Author’s Note: Notice that 65% of financings lost money for their investors.
Source: Correlation Ventures

“The new interesting commentary is that – where the job is getting harder – a lot of crossover funds are making binary bets. Finding the one deal that’s the next Salesforce – the next industry-defining company. And putting a lot of capital to find that one or two companies. Tiger and Coatue, still maintain that 10-12% IRR, but spend a lot to find the company that’ll be the next Databricks. Every generation has their industry-defining companies. And, they’re willing to lose it all to find that one.

“You usually don’t see this at the growth stage. It’s bad for innovation. Everyone is trying to find investments that are scaling. 1000 investments in the past year became unicorns. And there are 3000+ unicorns. Yet, the top five to seven companies are still undercapitalized.”

In closing

As we closed the selling part of our conversation, Ratan shared a great quote from an Economist article:

“Flush with cash amid a deal frenzy, what is the industry to do? One option would be to liquidate portfolios, that is, to sell more assets than it buys, in effect trying to cash in some chips when prices are high. As yet, however, this does not seem to be happening. Take the figures for three big managers, Blackstone, Carlyle and KKR. So far this year for every $1 of assets, in aggregate, that they have sold, they have bought $1.30. Although Carlyle is being more cautious than the other two firms, these figures indicate that the industry overall thinks the good times will roll on.”

In fairness, as the saying goes, the high risk, high reward. Data does show that the funds with the greatest track records have more deals that lose money than those make them more money than they invested.

Interestingly enough, there’s also a huge differential between the world’s most valuable and most funded startups. According to Founder Collective, “the most valuable companies raised half as much capital and produced nearly 4X the value!” All of which echo Ratan’s words. “The top five to seven companies are still undercapitalized.”

Source: Founder Collective

The public often looks towards invested capital as a proxy of startup performance. But the data suggests that isn’t the case. In the words of the team at Founder Collective, “capital has no insights.” One of my favorite lines from Ashmeet Sidana of Engineering Capital frames it is still: “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation.”

But when DPI boils down to selling on multiples at the end of the day, I often reference Samir Kaji‘s tweet on the return hurdles expected of different stages of investors. As you might guess, the return expectations of each type of fund varies based on fund strategy.

As all things in the world, exiting is just as nuanced and complicated as entering. Hopefully, the above insights will be another set of tools for your toolkit.

If this essay has inspired more questions, here are some further reading materials, courtesy of Ratan:

Photo by Visual Stories || Micheile on Unsplash

Thank you Shawn and Ratan for reading over early drafts.

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The Investor Purity Test

Many investors often take their job quite seriously. And they should. Imagine if your surgeon didn’t take the utmost care to do her job in the operating theatre. Or if your defense attorney walked in a courtroom lacking preparation. Investors, while not as life critical as a surgeon or your defense attorney, are in the business of selling and appreciating money. It’s as simple as that. And yes, more often than not, we use niche jargon. Though I’m not quite sure if it’s to isolate outsiders or to make ourselves sound smarter. Or both. Most conversations I’ve had to date with other VCs while insightful, are often, to the layman, quite esoteric.

So as a welcome break from the bustle of Silicon Valley, VC Twitter, and 30-minute coffee chats, I created the Investor Purity Test. In part for the memes. In part as a reference guide to those who want to grow to be more active VC investors.

Your purity starts at 100. In this “quiz”, there’s a checklist of 100 items. And with every item you check off, you slowly lose your purity to capitalism, specifically around early-stage financing. In a way, think of it like a VC “personality” test.

Have fun!

Top photo by Quino Al on Unsplash

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Three Types of Risk An Early-Stage Investor Takes

risk

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.

  1. Market risk as a function of ownership
  2. Judgment risk
  3. 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:

  1. Get in early.
  2. 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:

  1. Access to downstream capital or capital from strategic investors
  2. Access to talent – How can you increase the output of the business?
  3. Sales pipeline – How can you help grow revenue directly?
  4. 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.

Photo by Matthew Sleeper on Unsplash

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Where Does Implicit Gender Bias In The Startup World Come From

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.

Lack of Venture Dollars

Dana Kanze is an assistant professor of organizational behavior over at London Business School. She wrote a paper titled We Ask Men to Win and Women Not to Lose: Closing the Gender Gap in Startup Funding back in 2018 that won her the Academy of Management Journal’s Best Article of the Year award, which she inevitably did a TED talk on that I highly recommend checking out.

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.

Source: Crunchbase

And despite larger round sizes, we don’t see a rise in round sizes to female-only and mixed-gender teams either.

Source: Crunchbase

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.

Photo by Garrett Jackson on Unsplash

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