Two weeks ago, Ted Seides put out a great blogpost titled: The Investment Office Playbook – What Managers Don’t See. It’s the truth behind the veil of “It’s not you, it’s me” answer that LPs give. And that the best time for managers to be approaching CIOs at institutions happens to be:
1-2 years after they’re just sworn in (in other words, after they’ve figured out their strategy)
Up to 2-4 years after that period when they’re deploying against that strategy
And around years 11-13 where they’re now restructuring their portfolio after their previous portfolio has been optimized and reached maturity
Last week, Sequoia’s Jess Leeshared a fascinating product-market fit framework. Probably the best breakdown of solutions to problems mapping I’ve seen of late. It echoes much of what I’ve writtenbefore, but more eloquently put.
And the reason I bring this up is not to induce whiplash as you’re reading this blogpost. But that it relates back to when to raise from large LPs. As most of us know, there’s a strong correlation between fundraising as a founder and fundraising as a GP.
The first step is to have a product that large LPs can invest in. As a matter of fact, you need to have a specific product (aka fund strategy) for the LP you wish to court. For example, if a large LP’s minimum check size is $20M and their maximum ownership is 10%, and you’re a $50M fund, you don’t have what they’re looking for. That’s okay. You should never resize your fund purely on an LP’s check size and ownership.
The second is to understand their deployment timeline. In the case of large LPs, like endowments and pensions, that’s usually 2-4 years after a new CIO is sworn in. And years 11-13 when they’re rebalancing their portfolio. For other institutions, like some corporates, it’s actually in the bylaws that every three years, there’s a new Head of Investments. Hell, at Norges Bank Investment Management (NBIM) — the largest sovereign wealth fund, or at least one of the largest ones — a new CEO is sworn in every five years. So the clock is always ticking.
To the second point, for a large LP:
Years 1-2
When the new CIO is just sworn in, in many ways, that might be the best time to pitch a new paradigm. When the strategy has yet to fully shape up. Will you get many checks during that period? Likely not. Unless you’re a pre-existing trusted relationship of the CIO. But even if you do convince the CIO/team, they’re likely only allocating a very small percentage to that field, which for the most part, should work for you.
The goal of the value proposition, and subsequently the onboarding and tutorial, is to give people the activation energy needed to overcome the customer mindset. As such, it means one’s product can’t just be 10-20% better, but 10X better.
For instance, to get over the “yeah, right” and the “it is what it is” mindset, in the words of NFX’s Omri Drory, “the best way to manipulate energy, and get what you want, is to remove that ‘imagination barrier.'”
As such, the CIO must believe in the new paradigm. In all fairness, this takes more validation and big headlines for a tenured CIO to usually begin to believe these.
Years 2-4 (and 11-13)
They’re deploying against a top-down approach. And just as in years 11-13, they’re looking for the best in class solutions for each vertical. Meaning they’ll talk to hundreds of managers and look through thousands of pitches to pick just a few. Processes are long because they dig deep on these multi-fund relationships, but this is also an opportunity for them to increase the surface area for luck to stick.
While we all know past performance isn’t an indicator of future results, there is a reliance on metrics and the consistency of such metrics. For instance, if one were to take the top 2 investments in your portfolio and bottom 2 investments and throw them out, what does your remaining track record look like?
Or if some of your funds have yet to have meaningful distributions, graduation rates become rather important. Not just that on average, 30% of seed stage deals graduate to Series A. And 30% of Series A to B. But how many of your deals graduate past more than one subsequent round? For example, do more than 10% of your seed deals graduate to Series B? Although, to play my own devil’s advocate, vintages post-2019 have yet to really learn the true impact of loss ratios.
In closing
The truth is it’s hard to tell when the best time is. And oftentimes, it’s just a matter of luck. For one to have the right fund a specific LP is looking for at a time when liquidity is good.
But in many other ways, like Ted suggests in his blogpost, it’s the ability to think from the perspective of an LP that is invaluable and greatly appreciated as an LP.
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!
The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
In an industry that is heavily apprenticeship-driven, the more tactical advice one gets, the faster they grow. Historically, that meant a senior partner taking you under their wing. Or maybe 2-3. While I’ve been lucky to work and learn alongside some of the world’s most exceptional minds in the funding landscape, I’ve always found it helpful to have multiple teachers. Some in the form of books. Others in the form of shorter form content. Tweets. Social posts. Podcasts. And of course, from the insightful conversations that I have weekly. At the same time, in hopes of supporting the growth of others in this industry (such a small world, but it just isn’t helpful enough), this blog has been and will continue to be my vehicle for stewarding information and insights from the best.
Just like in both of my initial pieces of 99 pieces of advice for investors and founders I wrote in April 2022, this will be a continuation and an evolution of the last. While this will cover more of the same topics as last time, like startup investing, pitching to LPs, and fund strategy, I’m personally really excited about the some new categories, like succession planning, tax, and how to think about exiting positions.
And while I do write long form posts most of the time, and have been guilty of well… longerrrrrr form essays (and maybe one day with even more r’s), like this or this… I digress. While I do enjoy long form expositions, some things are best shared without superfluousness.
Most of the advice below captures the essence of a TikTok or Instagram Reel or a YouTube short. Choose your fancy. Many of which answers the age-old podcast question: “If you were to share one piece of advice with your [insert age]-year old self, what would it be?” Or “What advice would you give someone starting their first fund today?“
And now with “new and improved UI” (don’t get too excited, just number count of soundbites in each category), each fall in one of ten categories:
1/ You can’t be in every good deal, but every deal you’re in better be good.
2/ “You’re not defined by your worst investment. All angels will have failures in their portfolio. It’s part of the process.” – Brian Rumao
3/ “The weird thing is when late stage went from the hardest part of venture to the easiest. And that should have been the flag to everybody.” – Jason Lemkin*timestamped May 2022
4/ “The older you get, the younger your mentors should be.” – Samir Kaji
5/ “Your brand is what people say about you when you’re not in the room. It’s their first reaction when they see an email from you in their inbox. You build that brand — or not — with every interaction.” – Chris Fralic
6/ “Never let a good crisis go to waste.” – Winston Churchill
7/ When there’s risk involved, don’t let the outcome determine the quality of your decision. – Andy Rachleff
Investing — Deal flow, theses, diligence
8/ When assessing startups against their incumbents, consider their incumbents’ ability to hire top talent. For instance, if the incumbents are banks that are known for slower logistical and bureaucratic procedures, it’s easy to hire the best talent out there. On the other hand, if the incumbents are Coinbase, that’s still a fairly young, sexy company that’s innovating quickly, hiring top (technical) talent is more challenging. Shared by a former executive and founder with 2 exits, turned fund manager with 2 funds.
9/ If you’re not getting a call from a founder when they’re in trouble, you’re probably not getting a call from a founder when they’re raising their next big round. – Zach Coelius
10/ Pick great market inflection points to bet on. “The founder is the surfer. The product is the surfboard. The market is the wave. The wave matters most.” If you bet on a good surfer on a bad wave, they’re not going to get you the returns you want. Some Sequoia partner.
11/ Ask for investor updates (before investing). Before you invest, ask for the most recent investor updates. Helps you understand how founders think and communicate. – Brian Rumao
12/ Align with the founders, but also employees on valuations and dilution. – Nikhil Basu Trivedi
13/ The earlier you invest and the more you care about ownership, the more active role you’re expected to take in your portfolio company. You can’t expect to take large ownerships, and not actively help anymore. If you want to be a hands-off investor, you don’t have a right to fight for ownership. In a bull market, founders get picky about who’s on their cap table (as they should be). Focus on your check size to helpfulness (CS:H) ratio. Inspired by Jason Lemkin.
14/ “We have no fear. If we could find God’s phone number, we’d call him.” – David Beirne of Benchmark Capital fame, cited in eBoys. You are never too good to cold-call.
15/ Create a list of your favorite builders (i.e. engineers, community managers, executives, etc.). Then scrape Delaware incorporation docs regularly to see if any on the former list pop up in the search. If so, reach out to them early.
16/ Ask the founders to see different versions of the pitch deck. While we always say, “investors invest in lines, not dots”, oftentimes it’s hard to measure the slope (rather than y-intercept) when you’re meeting only with a founder at the beginning of their fundraise and not sooner. But one way to see is watch how much the pitch decks changed over time (and how quickly the founders incorporated feedback).
17/ Invest in companies that will be timeless. Where there will still be customers in a recession.
18/ If the competitors of the startup are being bought by private equity firms, then it may be a lucrative space to invest into. The competitors’ innovation slows, and optimizing for profit and the balance sheet becomes a priority when PE firms come in. – David Sacks
19/ There is a superpower to be speaking the same native language as the founders you back (and for them to their customers). Try to understand them for their position of strength.
20/ “The market you’re exiting in is not the one you’re funding now.” – Ben Narasin
21/ “There’s another phenomenon that happens in a time like this: Google’s not hiring. Facebook’s not hiring. People are clamping down. Guess what happens to their most advanced projects? They go. And guess who are the best people in any large company? The best people are working on the most advanced projects. They are the ones who want to do visionary things. They’re the fodder entrepreneur for venture capitalists. So I think many more of the best people — not because they’re not getting paid huge raises in compensation — but because they’re working on less interesting projects — will leave to follow their vision.” – Vinod Khosla (timestamped Oct 28, 2022)
23/ “Funny people are really underrated. […] Charismatic leaders are pretty funny. Humor is a really important emotion for two reasons. One is if you can evoke it a lot and be funny, you can create a sense of bonding. Generally speaking, in a remote world, there is a shortage of emotions you feel. An exchange between us now as we stare at each other in our computer monitors is maybe 1/100th of what it would have been in the real world. When you think about it, why do movies succeed? Movies substitute the real world interaction with synthetic emotion. So… horror, humor, action, drama. So you want leaders who can do the same over Zoom. That’s why Peloton instructors have all the jokes that they’re saying. It’s same exact effect.
“But there is a second reason to why humor matters, which is if you were to imagine a Maslow’s Hierarchy of Needs, I at least find with myself, I’m not able to think of a joke if basic stuff isn’t right. […] You do have to be careful of the ‘court jester’ type. These are people who are so insecure that they’ll do anything to get a [cheap] laugh.” – Daniel Gross. For example, cursing or vulgar jokes or making fun of others are examples of cheap laughter.
24/ For follow-on checks, Founders Fund and Saastr invest 10% of the fund in each of their “winners”. – Jason Lemkin
25/ “Whenever a CEO blames their bad performance on the economy, I knew I had a really crappy CEO. ‘Cause it wasn’t the economy, it was a bad product-market fit. The dogs didn’t wanna eat the dogfood. Sometimes the economy can make that a little worse, but if people are desperate for your product, it doesn’t matter if the times are good or bad, they’re going to buy your product.” – Andy Rachleff
26/ “[Peter Reinhardt] would put plants in different parts of the office in order for the equilibrium of oxygen and CO2 to be the same. He would put noise machines in the perfectly placed areas and then reallocate the types of teams that needed to be by certain types of noise so that the decibel levels were consistent. What I don’t think people realize about founders is that they are maniacal about the details. They are unbelievable about the things that they see.” – Joubin Mirzadegan
Value add
27/ Everyone says they’re a value add investor or founder friendly. And every founder goes through these 10-15 moments in their founder journey from which they lose sleep over. How many of your portfolio founders call you first if shit hits the fan? Those will be who you’re remembered by. No other portfolio founders will remember you.
28/ The network you bring is table stakes. That will neither help you win deals or raise LP capital when it really matters.
29/ “Dirty secret of VC platform teams: they are more about scaling the GP than the founder.” – Sarah Tavel
30/ Are you uniquely positioned to get allocation on the cap table because you can be a value add to these companies? – Vijen Patel
31/ Sometimes the most helpful thing you can do is to say no. When founders ask for introductions, and you don’t think they’re a good fit for your investor network, “It’ll be tough for you to fundraise right now. And if you jump in a conversation now with these other investors, it’ll hurt your ability to fundraise when you finally iron out those 1-2 key metrics and get to that inflection point.”
32/ Before the term sheet is signed, sit down with them and say this. “‘Listen. The chances this company gets to the finish line – the finish line being this fantastic exit – we don’t know what they are. But what I do know is that there is a chance, a high probability, that the company will fail. And I want you to think about this as an opportunity cost. I want you to think about every day you walk in the door to this company or turn on this Zoom as an opportunity cost. If it is not working, I want you to tell me, ‘It’s not working.’ And let’s have just a dispassionate conversation about what that means, so that we don’t waste any more time trying to make it work. And I promise you I will do the same.’
“And if you can set those guidelines from the beginning, you can move onto something that might have better timing. The founder can. And I can. Be aware of what failure looks like.” – Maha Ibrahim
Pitching to LPs
33/ Don’t promise your LPs guaranteed co-investing rights to go directly on the cap table of your portfolio companies. Let the founders decide who gets to invest on their cap tables. – Samir Kaji.
34/ A typical emerging fund takes 1-2 years to raise <$10M. Plan for that timeframe. A fast raise is 6 months. – Elizabeth Yin*timestamped April 2022
35/ To LPs there are 4 main metrics that are of note. Gross and net IRR to show how cash efficient you are, as well as how your portfolio is marked up. TVPI and DPI to show your paper returns and cash you’ve returned to your LPs, respectively. – Chamath Palihapitiya
36/ When you’re pitching institutional LPs (i.e. endowments, pension funds, university investment offices, etc.), you’re bet against 10-year life cycles and portfolio strategies. When benchmarking metrics (i.e. IRRs and TVPIs/DPIs), you have to show you can outperform other asset classes (i.e. real estate) and the public market equivalent (PME). Comparing and contrasting is often the most effective.
37/ When you’re pitching individual LPs (i.e. angels, or “belief capital), largely true for Fund I’s and II’s, it’s about personality and promise. Do people like you? Do you bring in great top of funnel deals? Are you different?
38/ “Don’t run out of leads.” You want to be constantly meeting new investors, ’cause you don’t want to be in a situation where you have to go back and convince people who are clearly not sold. – Elizabeth Yin
39/ If your Fund I consists of mostly individual LPs (i.e. accredited investors, but not qualified purchasers), you’re going to have to fundraise from scratch in Fund II and III. Since they have less of a net worth than institutional LPs, they most likely don’t have the capital to: (a) re-commit for a subsequent fund, (b) and even if they do, they won’t have enough to meet the minimum check size, assuming Fund II/III is bigger than Fund I. Inspired by Elizabeth Yin.
40/ Ask LPs what they like and what they don’t like about the pitch deck, and use each conversation as a learning and refining process.
41/ Figure out how much money you’re capable of raising in Fund I, and raise 25% less. It’s much better to be oversubscribed than suffer from lack of momentum. And leverage the “oversubscription” to help you raise Fund II, III, and so on. Told me to by someone who has sat on over 6 LPACs(LP advisory committees) in his career so far.
42/ The median family office check into first-time fund managers is $750K, with over 80% of family offices investing into first-time managers.
43/ “Does the world need another VC fund?” Most LPs don’t think so, so you need to convince them why you should exist.
44/ Before wasting your time pitching to some LPs, ask “Are you actively investing in venture funds at this time?” Many take meetings, but aren’t. Your time is precious.
45/ You’re going to raise from friends and family in the beginning. Your second cohort of LPs will be people you have a substantial network to. In other words, investors who you have many duplicate warm connections with, so that they can easily qualify your ability. – Dylan Weening
46/ In a recessionary market, LPs find themselves rebalancing their asset allocations. As their public market assets go down, they find themselves overallocated into venture. As such, they’re investing in less new managers. So in order to raise as an emerging GP from these LPs, you need to replace someone they’re currently investing into. That means you need to: (a) outperform them (4x TVPI is table stakes), and (b) have one compelling story on why you, backed by numbers.
47/ When doing diligence, sophisticated LPs evaluate you based on consistency. They will evaluate fund/portfolio performance with AND without your top investment. Hence, they expect a minimum number of investments in your portfolio – usually 20 to 30.
48/ Some LPs have been burned by staying invested in yesterday’s firms for too long. The top firms a decade ago are not the same top firms today. These firms often have an emerging GP thesis.
49/ “This is not a one-trick-pony relationship. You’re a capital allocator. The cost of finding new relationships to build is significant. You need to seek long-term capital allocation partners. Have a three to five fund view – multi-decade relationships. How repeatable is your success?” Shared by an LP in 30 funds.
50/ “The best filter for this is figuring out what [an LP’s] minimum check size is. And, is that greater than 20% of your fund size? If so, it won’t be a good fit.” – Sarah Smith
51/ “There’s a thing called ’round tripping.’ If a fund in India invests in a fund that’s built in the US, then invests back into Indian startups, that’s round tripping. And unfortunately, not allowed.” – Shiva Singh Sangwan
52/ “Before you say yes to LPs, check the CFIUS rules. Under those guidelines, you may not be able to take money from certain countries and parties.” – Arjun Dev Arora
53/ “Valuations are not the way you judge a venture capitalist, or multiples of their fund. […] The way that I judge a venture capitalist is by how many companies did they back that grew into $100M revenue businesses.” – Andy Rachleff
Fund strategy/portfolio construction
54/ It’s often good practice to not lead syndicates the same time as you’re raising for a fund (outside of SPVs to maintain pro rata). It gives too much optionality to LPs. For the most part, it’s easier sell a deal than it is to sell a fund.
55/ Typical GP commits are 1-2% of the fund. If you’re unable to do so (or even if you are), good practices include recycling fees and deal warehousing. The latter is where you keep a portfolio of personal investments in storage before launching the fund. Warehousing deals de-risk the deal by allowing LPs to participate in marked-up deals at more lucrative, aka lower valuations.
56/ In a downturn, investors are still funding startups but adding in more terms in the form of side letters. The riskier the bet, the greater the liquidation preferences, anti-dilution provisions, and minimum hurdle rate expectations.*timestamped in April 2022
57/ “Bank loans for VC funds have short paybacks (90-180 days). The 2+ year paybacks relate to large PE funds. IRR boost is minimal in VC.” – Samir Kaji
58/ Don’t be scared to recycle carry early. Most funds suffer from under-deployment, which usually leads VCs to deploy the last 25% of capital either towards deals with high valuations or in difficult situations (down rounds, pay to play rounds). – Villi Iltchev
59/ While pro rata rights are technically legally binding, earn the right to invest in subsequent rounds, rather than just expect it.
60/ Liquidation preferences have little impact on fund returns, which makes sense when you actually think about it, but many VCs add these provisions to protect their downside. Data shows that only the bottom quartile funds see IRR impacted greater than 1% due to liquidation preferences. Returns are driven by the winners in your portfolio where liquidation preferences don’t matter. There’s a big difference in a strategy to win versus a strategy not to lose.
61/ IRR is a vanity metric for funds early in their life cycle. While it can be a useful metric for LPs to compare across vintages and their portfolio, overoptimizing for it gives a false sense of hope. Why? IRR values quick capital deployment. Recycling hurts IRR. Many things change over the span of a 10-15 year fund. – Seth Levine.
62/ Ownership and pro rata allocations are inversely proportional to the number of portfolio companies in a fund. Many managers can’t get 100% of their pro rata allocations, but rather only 50-75% of their allocations. Inspired by Henri Pierre-Jacques.
63/ Venture reserves make less sense in a bull market. Reserves are usually put into a fund’s winners. But in a hot market, a larger percentage of your portfolio companies get mark ups – making it harder to differentiate signal from noise. Reserves make sense in a bear market when it’s easier to differentiate signal from noise. In a bull market, it might be better to have no reserves, and spin up SPVs for a follow-on strategy.
64/ Your ability to get into later rounds, not just ’cause of pro-rata rights, should be a big determinant if you have a reserve strategy. Can you earn your allocation in later rounds? Will founders fight for you even when downstream investors want more equity? The best companies are hot commodities. Even if you have a follow-on strategy, you might not be able to get in those subsequent rounds.
65/ If you want to include more than 99 accredited investors in your fund, set up a parallel structure where you have one fund for accredited investors (<$10M) to include 249 accredited investors, and another fund for qualified purchasers (QPs).
66/ “The best way to protect yourself against the downside is to enjoy every bit of the upside.” – Bill Gurley
67/ If you have a parallel fund structure (i.e. one for accredited investors, one for qualified purchasers (QPs)) and you’re going through rolling closes, understand that your initial allocation in each deal will change as a function of each fund’s committed capital from LPs.
For example, let’s say you’re raising a hypothetical $100M fund – a $10M fund for accredited investors, and $90M for QPs. Let’s call the $10M fund Fund IA, and the $90M fund Fund I. On average, QPs take much longer to make a decision, so you’re likely to close your Fund IA before you close Fund I. As such, your first investments out of the fund might be 50-50 from each fund. But as you finish closing your Fund I, you will need to rebalance your allocation into earlier deals, like changing it from a 50-50 allocation between the two funds to 90-10. As such, in your term sheets, make sure you include the “right to transfer securities to affiliates.” And make it clear to your founders why that’s in there before everyone signs.
68/ If you’re building a concentrated portfolio, think about portfolio construction from a bottom-up perspective, rather than top-down. How many unicorns/decacorns do you need to return the fund? How often have you historically seen them in your inbox? That’ll be your deployment schedule. And subsequently, your capital call schedule.
69/ “Fund management is irrelevant unless there are winners in the portfolio.” – Laura Thompson
70/ Calculate your mark ups on priced rounds rather than valuation caps on SAFEs. Your TVPI and IRR may look nice in the short-term, and may help you raise from individual LPs. But once you start talking to institutions, you look deceitful or have no idea what you’re doing.
71/ Avoid overly large GP commits. If you invest too much of your own net worth into a fund, you’re going to make decisions that sacrifice the long game of the fund for short term personal liquidity, like selling secondaries to buy a house. Don’t go higher than 10% of your net worth. – Sheel Mohnot
72/ “For funds that are <$20MM, the GP commitment is fairly meaningless in the evaluation of a fund. Either the person is already taking a great opportunity cost by running such a small fund or has independent personal wealth where a small GP commitment is irrelevant to them.” – Samir Kaji
73/ “Most LPs allow you to reinvest returns 18-36 months after the investment period. The early wins are often small and don’t impact the returns so you are better off reinvesting to go for another unicorn. This is a game of outliers.” – Henri Pierre-Jacques
74/ “Management fee schedule adjustments: Pause or slow down fees in ’23 (with authority delegated to LPAC to avoid conflicts of interest)” – Chris Harvey (timestamped Feb 13, 2023). A way to leverage your LPAC to communicate fund decisions to the rest of your LPs
75/ “What % of companies successfully got funded from investment to the next round?
Seed —> Series A should be >35%.
Series A —> Series B should be >50%.
Series B —> Series C should be >50%.
And, Series C —> Series D+ should be >60%.” – Aman Verjee
76/ As a long-term investor, you have to generate at least three times the risk-free rate (3-month T-bonds, bank interest rates, etc.) to have an investment make sense in the long-term. – Chamath Palihapitiya, speaking when T-bonds’ rate is 6.5%, meaning a private investment must generate at least 20-25% for it to make sense
Selling positions
77/ “In consumer and consumer social, advocate more aggressively for selling along the way. The hype cycle of consumer means heat and traction do not have the sustainability of enterprise ARR and so more weight placed on selling some portion earlier there.” – Harry Stebbings
78/ “Pigs get fat but hogs get slaughtered. Even if we believe a company has tremendous longterm upside, it’s not inappropriate to take some money off the table in order to manage that risk. As we’re recently reminded, markets go down, not just up. Just be aware of the incentives, emotions, and other factors at play. It’s ok to behave one way before you hit your DPI target and another way after, but understand how those factors produce better or worse possible outcomes. This is also true with regards to recycling. If we can sell partially out of a position and put those proceeds into one that we believe has more incremental upside, that’s accretive to our results.” – Hunter Walk
79/ “Generally once a position is worth 3x the fund sell 1/3rd to return 1x the fund (if there is liquidity). […] For the hot names you will get a bunch of inbound. Negotiate to get a price you like. For less hot names, just talk to the investors leading the next round and see if they want to add to their position. A lot of times they do and don’t mind buying out earlier investors.” – Sheel Mohnot
80/ “For public shares, we’ve landed on the following model:
1/3rd immediately (either first-day lockup expires or immediate on direct listing)
1/3rd 6 months after
1/3rd up to our discretion
Here’s why — The first third books your win. If you do seed, you likely have a huge position by the time you hold public shares. The second third allows the stock price to stabilize after the market has been hit with lots of supply from VCs doing distributions. The last third allows you to have an opinion on the stock/market — however, you can choose to distribute this third anytime, including alongside or after the previous thirds.” – Chad Byers
81/ If you’re a reasonably good fund, you should return at least 1x your fund (1x DPI) within 5-7 years. – Chamath Palihapitiya and Jason Rowley
LP management
82/ Early funds generally have 30 LPs in the fund. Fund I is often an exception.
83/ A general rule of thumb is to not have any one LP contribute more than 25% of the fund, or else you might lose control when you have such a large “shareholder”.
84/ “After my LPs wire their money, I send them an intake form where I ask the question: How would you describe yourself as an LP? I have a number of statements they can select to indicate whether they are a newer or more experienced LP, if they’d like to be more active with founders, how often they’d like to communicate with me, and if they are interested in co-investment opportunities and events. I have another question following that: If you want to be more active, what are ways you enjoy helping?” – Sarah Smith
85/ “Be thoughtful about how you’re managing your time, so that you don’t turn into a full-time venture professor. You’re an investor, a GP. That’s what you’re getting paid to do.” – Arjun Dev Arora
86/ “Avoid LPs who ask you to give up economics as a GP or change your terms. LPs who want to negotiate lower management fees, a different carry structure, or they want to own 20% of the general partnership for the next three funds are best avoided if possible. They want to change the terms that everyone else has. I wouldn’t allow that. If other LPs find out (and they eventually do), it would cause my LPs to lose trust in me and rightfully be frustrated that they got worse terms.” – Sarah Smith
87/ “If someone does ask for it, and if they aren’t a large enough check, we tell them, ‘We like to reserve this spot for our largest LPs because they have the largest exposure in our fund. We’re open to you being a member in our LPAC, if you increase your check size.” That way, you can leave the ball in their court. Either, they won’t push further or they’ll commit more capital to the fund.” – Eric Bahn
88/ “If you’re in your Fund I or II, like I am, you’re still figuring shit out. You’re still testing what works and resonates and what doesn’t. I ask them, ‘what have you seen other managers do in this situation?’” – Paige Finn Doherty
89/ “The average, for a normal venture fund, is around 5-7 years to call 90% of the capital.” – Chamath Palihapitiya
SPVs/Syndicates
90/ There are two types of syndicate leads: “marketers” and “connoisseurs.” The former focuses on volume, which lead to more noise than signal. The latter focuses on quality, and as “tastemakers” lead to higher signal over noise. As LPs, quality may matter more than quantity, especially when you’re most likely diversified by being in several other syndicates already. Inspired by Julian Weisser.
91/ If you’re warehousing SPVs for your fund, do note that the number of unique LPs in your SPV(s) count towards your accredited investor limit.
92/ If you’re an LP in an SPV and agree for it to be warehoused into a fund, you are forgoing your right to the individual deal for access to the fund’s portfolio of deals.
93/ As the syndicate lead, set the minimum check size at or less than your own check size.
94/ Your GP commit into your SPV is directly proportional to your net worth. The greater your net worth, the more you’re expected to contribute. Any less, would be a negative signal. That said, the less of a net worth you have, the more you’re expected to be a great curator of deals.
Succession planning
95/ “The best way to think about succession planning is that you have to have team members at different parts of their life. Different generations. Even if they’re non-founding partners, if they all retire at the same time, you can’t build a legacy.” – An investor with 9-figure AUM
96/ Structure your fund to have a generational off-ramp for compensation. A lot of funds are structured so that payout is done through the management company, and so owning equity in the management company becomes increasingly more expensive as the firm matures and has greater AUM, etc. So the next generation, in order to succeed the firm, must buy out the previous generation’s equity. So, leadership transitions are not easy. Instead, structure your firm so that the management company doesn’t have value, where the value is at the GP. So transitions are a lot easier. – Maha Ibrahim
Tax planning
97/ When invest in a startup via SAFEs or convertible notes, your QSBS timer counts when the SAFE converts on equity round, not during the convertible round.
98/ As a GP who takes management fees through a management company, often LLC, you don’t receive W-2’s. As such, you can’t withhold taxes, so you have to be disciplined on cash management. “Outside of federal and state tax, there is a massive self-employment tax of 12.4% on up to $147,000 of earnings. And an additional 2.9% on any earnings.” – Jarrid Tingle
99/ The origin of the 1% GP commit comes from taxation laws prior to 1996. But even now, “in order for GPs to avoid their carried interest being taxed as ordinary income vs. long-term capital gains, many GPs still follow safe harbor.” – Courtney McCrea and Sara Zulkosky. While this isolates GPs who aren’t independently wealthy or are well-capitalized, in lieu of the typical cash contribution, I see a lot more emerging GPs warehouse deals and recycle carry.
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!
The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
Humans are terrible at understanding percentages. I’m one of them. An investor I had the opportunity to work with on multiple occasions once told me. People can’t tell better; people can only tell different. It’s something I wrestle with all the time when I hear founder pitches. Everyone claims they’re better than the incumbent solution. Whatever is on the market now. Then founders tell me they improve team efficiency by 30% or that their platform helps you close 20% more leads per month. And I know, I know… that they have numbers to back it up. Or at least the better founders do. But most investors and customers can’t tell. Everything looks great on paper, but what do they mean?
When the world’s wrapped in percentages, and 73.6% of all statistics are made up, you have to be magnitudes better than the competition, not just 10%, 20%, 30% better. In fact, as Sarah Tavel puts it, you have to be 10x better (and cheaper). And to be that much better, you have to be different.
And keep it simple. As Steve Jobs famously said that if the Mac needed an instruction manual, they would have failed in design. Your value-add should be simple. Concise. “We all have busy lives, we have jobs, we have interests, and some of us have children. Everyone’s lives are just getting busier, not less busy, in this busy society. You just don’t have time to learn this stuff, and everything’s getting more complicated… We both don’t have a lot of time to learn how to use a washing machine or a phone.”
If you need someone to learn and sit down – listen, read, or watch you do something, you’ve lost yourself in complexity.
“Big-check” sales is a game of telephone. For enterprise sales or if you’re working with healthcare providers, the sales cycle is long. Six to nine months, maybe a year. The person you end up convincing has to shop the deal with the management team, the finance team, and other constituents.
For most VCs writing checks north of a million, they need to bring it to the partnership meeting. Persuade the other partners on the product and the vision you sold them.
And so if your product isn’t different and simple, it’ll get lost in translation. Think of it this way. Every new person in the food chain who needs to be convinced will retain 90% of what the person before them told them. A 10% packet loss. The tighter you keep your value prop, the more effective it’ll be. The longer you need to spend explaining it with buzzwords and percentages, the more likely the final decision maker will have no idea why you’re better.
Humans are terrible at tracking nonlinearities. While we think we can, we never fully comprehend the power law. Equally so, sometimes I find it hard to wrap my hear around the fact that 20% of my work lead to 80% of the results. While oddly enough, 80% of my inputs will only account for 20% of my results. The latter often feels inefficient. Like wasted energy. Why bother with most work if it isn’t going to lead to a high return on investment.
Yet at the same time, it’s so far to tell what will go viral and what won’t. Time, energy, capital investments that we expect to perform end up not. While every once in a while, a small project will come out of left field and make all the work leading up to it worth it.
When I came out with my blogpost on the 99 pieces of unsolicited advice for founders last month, I had an assumption this would be a topic that my readers and the wider world would be interested in. At best, performing twice as well than my last “viral” blogpost.
Cup of Zhou readership as of April 2022
Needless to say, it blew my socks off and then some. My initial 99 “secrets”, as my friends would call it, accounted for 90% of the rightmost bar in the above graph. And the week after, I published my 99 “secrets” for investors. While it achieved some modest readership in the venture community and heartwarmingly enough was well-received by investors I respected, readership was within expectations of my previous blogposts.
My second piece wasn’t necessarily better or worse in the quality of its content, but it wasn’t different. While I wanted to leverage the momentum of the first, it just didn’t catch the wave like I expected it to.
Of course, as you might imagine, I’m not alone. Nikita Bier‘s tbh grew from zero to five million downloads in nine weeks. And sold to Facebook for $100 million. tbh literally seemed like an overnight success. Little do most of the public know that, Nikita and his team at Midnight Labs failed 14 times to create apps people wanted over seven years.
When Bessemer first invested in Shopify, they thought the best possible outcome for the company would be an exit value of $400 million. While not necessarily the best performing public stock, its market cap, as of the time I’m writing this blogpost, is still $42 billion. A 100 times bigger than the biggest possible outcome Bessemer could imagine.
Humans are terrible at committing to progress. The average person today is more likely to take one marshmallow now than two marshmallows later.
Between TikTok and a book, many will choose the former. Between a donut and a 30-minute HIT workout, the former is more likely to win again. Repeated offences of immediate gratification lead you down a path of short-term utility optimization. Simply put, between the option of improving 1% a day and regressing 1% a day, while not explicit, most will find more comfort in the latter alternative.
James Clear has this beautiful visualization of what it means to improve 1% every day for a year. If you focus on small improvements every day for a year, you’re going to be 37 times better than you were the day you started.
While the results of improving 1% aren’t apparent in close-up, they’re superhuman in long-shot.
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, investment, business, or tax advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.
I want to preface; I don’t have all the cards laid out in front of me. In many ways, I am still trying to figure this out for myself. But I count myself lucky to be able to learn from some of the best in building communities. That said, the below are my views alone and are not representative of anyone or any organization.
A good friend recently asked me, “I’m about to start a community. Do you have any tips for how to start one with a bang?”
She’s not alone. Communities have been a hot topic for the past few years. A product of the crypto and NFT craze, and the isolation people felt when the world was forced to go virtual in 2020. At the same time, starting a community and maintaining/managing a community are different. Just like starting a company and growing a company are two different job descriptions. As such, this essay was written with the intention of addressing the former, rather than the latter.
Common traits of great communities
A great community has value and values.
Value is the excuse to bring people together. Value answers the question: why should I join? And within the first week, they should also have the answer to: why should I stay? Two fundamentally different questions. Many communities frontload the value – provide great value at the beginning – facilitating intros, onboarding workshops and socials. Subsequently, answers the first question, but take the second for granted. A community is the gift that keeps on giving. Over time, as you want to be able to scale your time and as the community grows, you need others to help you provide the reason for Why should I stay. Invariably, it comes down to people. You have to pick uncompromisingly great people from the start. And they have to derive so much value from being a part of the community, that demands converts to supply.
They refer others.
They give back to the community – in the form of advice, hosting events, and more.
Value should also be niche – just like the beachhead market for any startup. You want people to self-select themselves out of it, and the only people who stick around are the ones who derive the most benefits from being in it. Take, for example, a community of founders isn’t niche. And there a dime a dozen of the above. A community of pre-seed female founders focused on getting to product-market fit, is.
Values, on the other hand, are the rules of engagement. Codify them early. Take no implicit agreement for granted. Better yet, make them explicit. Back in January 2020, I wrote about rules in the context of building startup culture. I find the same to be true when building communities. “Weak follow-through is another fallacy in creating the culture you want. What you let slide will define the new culture, with or without your approval.”
I don’t mean for you to be a hard-ass on everything. But figure out early on how much slack you’re willing to give, and how much you aren’t. I’ve written about this before. Every person will suck. Every organization will suck. And unsurprisingly, every community will suck. What differentiates a great community from a good community is that the great ones get to choose what they’re willing to suck at.
You should be exclusive
Moreover, my hot take is that you have to be exclusive. Or let me clarify… in the wealth of Slack groups and Discord servers, yet in the world where everyone still has a job (or two), friends, family, and other communities they’re already a part of that all already slice up their 24-hour day pie in so many different ways, you are competing for their attention. If you’re a community, you’re competing against Instagram, Twitter, TikTok, Friday happy hours, Saturday nights out with the girls, date night with their partner, eight hours of sleep, their workout routine, and so much more. And so, you have to be inclusive of those who have been excluded. As such, you have to exclude those who have historically been included.
I’m not saying that you should start a community for the underestimated just ’cause. It’s like starting a business because you want the title of CEO. Don’t do it. It’s not worth your time. It’s not worth your energy. But you have to be honest with yourself, are you adding more value in the world? Is there anyone else who would sacrifice their other commitments to belong in your community? And do you have the discipline and the drive to maintain this community in the long term? The worst thing you can do is create a new home for someone then take it away.
Building and rebuilding habits
When starting a community, you are asking individuals to build a new habit. One of your greatest competitors is the incumbent solution of existing habits and routine. Some research cites that it takes 21 days to break a habit. And about two months to build a new one. All in all, 90 days all things considered.
Elliot Berkman, Director of University of Oregon’s Social and Affective Neuroscience Laboratory, surmises that there are three factors to breaking a habit.
The availability of an alternative habit
Strength of motivation to change
Mental and physical ability to break the habit
To break down the above:
The availability of an alternative habit
How available is the replacement behavior? Are there other communities out there that do the exact same thing? How well known are they? What are their barriers to entry?
If there is a readily available alternative community, the first question you need to answer is: why bother making another? Realistically, any one person only has enough time and attention to be in 2-3 communities – total. The second question you need to answer is: how do people normally learn of that community? And subsequently, is there a market or audience who doesn’t have access to this distribution channel? If so, what channels occupy most of their attention? Target those.
Strength of motivation to change
There’s a saying in the world of marketing that goes something along the lines of: People don’t buy products. They buy better versions of themselves. Therefore, as a community, you need to nail the value you provide. Is it aspirational? Does it get people to jump out of their seats and scream yes?
A simple litmus test is if you were to share the reason you created the community, do they respond with “How do I sign up for this now?” or “Let me think about it.”? If the latter, you haven’t nailed your value proposition. In other words, what you’re selling isn’t aspirational. Or if it is, you’re either talking to the wrong demographic or the value proposition is a 10% improvement in people’s lives, not a 10x. Sarah Tavel‘s “10x better and cheaper” framework (albeit for startups) is a great mental model for nailing your value prop. Your community must be:
So much better than the incumbent solution or habit they regress to, and
Easy to jump on (i.e. switching costs must be low enough for it be a no-brainer) – Sometimes this means you need to manually onboard every individual into your community. And sometimes all one needs is an accountability partner. Everyone wants be THE number that matters, not just A number. Make people feel special.
Mental and physical ability to break the habit
This is admittedly the factor that is most outside of your immediate control. Here, I regress to the below nerdy formula I made up in the process of writing this blogpost:
(how much work you need to put into each member) ∝ 1/(# of members)
The amount of work you need to put into inspiring each member to join is indirectly proportional to the number of members you can accommodate in your community. In other words, the less you need to convince people to join your community, the more members you can accommodate. The more time you need to inspire enough activation energy for a person to build a new habit, the smaller the initial cohort of members you can tailor to.
This is why I love the concept of the idea maze so much. Has your target community members put in blood, sweat, and tears trying to find the value that you are providing? Why does this matter?
They’ve designed their life already around finding answers around your value prop. They’re going to be more engaged than the average individual. They’re intrinsically motivated to be curious.
Shared empathy. They know how tough finding an answer is, such that they’re more willing to help others going through similar problems.
The shared struggles that people collectively and synchronously go through together build camaraderie and trust. No matter how small or big. The bonds of a sports team are built upon the sweats and tears of brutal training regimens, losses and wins. The trust of a Navy Seals class is built through Hell Week, pain, exhaustion, adversity, and (the likelihood of) death. And, the friendships between college freshmen are built through the unfamiliar environment of a new and daunting chapter of their life.
In closing
Starting a community is hard. 99% of communities (don’t quote me on this number, but I know I’m close to the mark) disappear into obsolescence after their founders lose their motivation. Oftentimes even prior. Not only are you cultivating a new habit yourself, but you are doing so for everyone else you want in your community. I hope the above was able to illuminate your thinking as much as it did for me. I continue to learn and iterate, and as such, will likely publish more content on this topic in the future. For now, this essay will be my thoughts encased in amber.
A big thank you to everyone who’s influenced and will continue to influence my thoughts on community, including but not limited to Sam, Andrew, Mishti, Jerel, Shuo, and most recently, Enzo.
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, investment, business, or tax advice. Please do your own diligence before investing in startups and consult your own adviser before making any investments.
Not too long ago, I quoted Phil Libin, founder of All Turtles and mmhmm (which has been my favorite virtual camera in and most likely post-pandemic), who said: “I think the most important job of a CEO is to isolate the rest of the company from fluctuations of the hype cycle because the hype cycle will destroy a company. It’ll shake it apart. In tech the hype cycles tend to be pretty intense.”
Hype is the difference in expectation and reality. Or more specifically, the disproportionate surplus of expectation. A month ago, Sarah Tavel at Benchmarkwrote: “Hype — the moment, either organic or manufactured, when the perception of a startup’s significance expands ahead of the startup’s lived reality — is an inevitability. And yet, it’s hard not to view hype with a mix of both awe and fear. Hype applied at the right moment can make a startup, while the wrong moment can doom it.”
Right now, we are in a hype market. And hype has taken the venture market by storm.
We’ve all been seeing this massive and increasing velocity and magnitude of capital deployment over the last few months. Startups are getting valued more and more. In the past, the pre-money valuations I was seeing ranged from 2-on-8 to 3-on-9. Or in not so esoteric VC jargon, $2M rounds on $8M pre-money valuations ($10M post-money) to $3M rounds on $9M pre-money valuations ($12M post-money). These days, I’ve been seeing 5-on-20 or 6-on-30. Some of which are still pre-traction, or even pre-product.
Founders love it. They’re getting capital on a discount. They’re getting greater sums of money for the same dilution. Investors who invested early love it. Their paper returns are going through the roof. When looking at IRR or TVPI (total value to paid-in capital – net measurement on realized and unrealized value), higher valuations in their portfolio companies are giving investors jet fuel to raise future funds. And greater exit values on acquisition or IPO mean great paydays for early investors. Elizabeth Yin of Hustle Fundsays “this incentivizes investors to throw cash at hyped up companies, instead of less buzzy startups that may be better run.”
Sarah further elaborated, “In the reality distortion field of hype, consumers lean in and invest in a platform with their time and engagement ahead of when they otherwise might have. They pursue status-seeking-work, not because they necessarily get the reward for it relative to other uses of their time, but because they expect to be rewarded for it in the future, either because of the typical rich-get-richer effect of networks, or just in the status of being an early adopter in something that ends up being big.” The same is true for investors investing in hyped startups. It’s status-seeking work.
Frankly, if you’re a founder, this is a good time to be fundraising.
Why?
Capital is increasingly digital.
There is more than one vehicle of early stage capital.
There are only two types of capital: Tactical capital and distribution capital.
1. Capital is increasingly digital.
Of the many things COVID did, the pandemic accelerated the timeline of the venture market. Pre-pandemic, when founders started fundraising, they’d book a week-long trip to the Bay Area to talk to investors sitting on Sand Hill Road. Most meetings that week would be intro meetings and coffee chats with a diverse cast of investors. Founders would then fly back to their home base and wait to hear back. And if they did, they would fly in once again. This process would inevitably repeat over and over, as the funnel grew tighter and tighter. And hopefully, at the end of a six-to-twelve month fundraise, they’d have one, maybe a few term sheets to choose from.
Over the past 18 months, every single investor took founder meetings over Zoom. And it caused many investors to realize that they can get deals done without ever having to meet founders in-person. Of course, the pandemic forced an overcorrection in investor habits. And now that we’re coming out of isolation, the future looks like: every intro meeting will now be over Zoom, but as founders get into the DD (due diligence) phases or in-depth conversations, then they’ll fly out to meet who they will marry.
It saves founders so much time, so they can focus on actually building and delivering their product to their customers. And,
VCs can meet many more founders than they previously thought possible.
This has enabled investors to invest across multiple geographies and build communities that breathe outside of their central hub or THE central hub – formerly the SF Bay Area. Rather, we’re seeing the growth of startup communities around the nation and around the world.
2. There is more than one vehicle for early stage capital.
While meetings have gone virtual, the past year has led to a proliferation of financing options in the market as well. Capital as jet fuel for your company is everywhere. Founders now have unprecedented optionality to fundraise on their terms. And that’s great!
Solo capitalists
Individual GPs who raise larger funds than angels and super angels, so that they can lead and price rounds. The best part is they make faster decisions that funds with multiple partners, which may require partner buy-in for investments.
Rolling funds
With their 506c general solicitation designation, emerging fund managers raise venture funds faster than ever and can start deploying capital sooner than traditional 506b funds.
Micro- and nano-VCs
Smaller venture funds with sub-ten million in fund size deploying strategic checks and often leverage deep GP expertise. No ownership targets, and can fill rounds fast after getting a lead investor.
Equity crowdfunding
Platforms, like Republic and SeedInvest, provide community-fueled capital to startups. Let your biggest fans and customers invest in the platform they want to see more of in the future. With recent regulations, you can also raise up to $5 million via non-accredited and accredited investors on these platforms.
Accelerators/incubators
Short three-month long programs, like Y Combinator, 500 Startups, and Techstars, that write small, fast checks (~$100K) to help you reach milestones. Little diligence and one to two interviews after the application. Often paired with an amazing investor and/or advisor network, workshops, powerful communities, and some, even opportunity funds to invest in your next round.
Syndicates/SPVs
Created for the purpose of making one investment into a company a syndicate lead loves, syndicates are another ad hoc way of raising capital from accredited investor fans, leveraging the brand of syndicate leads and deploying through SPVs. Or special purpose vehicles. I know… people in venture are really creative with their naming conventions. In turn, this increases discoverability and market awareness for your product.
SPACs and privates are going public again
Companies going public mean early employees have turned into overnight millionaires. In other words, accredited investors who are looking to grow their net worth further by investing in different asset classes. Because of the hype, investing in venture-scale businesses tend to be extremely lucrative. These investors also happen to have deep vertical expertise, high-value networks, as well as hiring networks to help startups grow faster. More investors, more early stage capital.
Growth and private equity are going upstream
Big players who usually sat downstream are moving earlier and earlier, raising or investing in venture funds and acceleration programs to capture venture returns. And as a function of such, LPs have increased percent distributions into the venture asset classes, just under different names.
Pipe
Pipe‘s existed before the pandemic, but founders have turned their eye towards different financing options, like Pipe. They turn your recurring revenue into upfront capital. Say a customer has an annual contract locked in with you, but is billed monthly. With Pipe, you can get all that promised revenue now to finance your startup’s growth, instead of having only bits and pieces of cash as your customers pay you monthly. Non-dilutive capital and low risk.
3. There are only two types of capital: Tactical capital and distribution capital.
There’s an increasingly barbell distribution in the market. Scott Kupor once toldMark Suster that: “The industry’s gonna bifurcate. You’re going to end up with the mega VCs. Let’s call them the Goldman Sachs of venture capital. Or the Blackrock of venture capital. And on the other end, you’re going to end up with niche. Little, small people who own some neighborhood whether it’s video, or payments, or physical security, cybersecurity, physical products, whatever. And people in the middle are going to get caught.”
Those “little, small” players have deep product and go-to-market expertise and networks. Their checks may be small. But for an early stage company still trying to figure out product-market fit, the resources, advice, and connections are invaluable to a startup’s growth. They’re often in the weeds with you. They check your blind side. And they genuinely empathize with the problems and frustrations you experience, having gone through them not too long ago themselves. Admittedly, many happen to be former or active operators and/or entrepreneurs.
On the flip side, you have the a16z’s and Sequoias on their 15th or 20th fund. Tried and true. Brilliant track record with funds consistently north of 25% IRR. Internal rate of return, or how fast their cash is appreciating annually. LPs love them because they know these funds are going to make them money. And as any investor knows, double down on your winners. More money for the same multiples means bigger returns.
The same is true for historical players, like Tiger, Coatue, and Insight, who wire you cash to scale. They assume far less risk. Which admittedly means a smaller multiple. And to compensate for a lower multiple, they invest large injections of capital. By the time you hit scale, you already know what strategies work. All you need is just more money in your winning strategies.
You find product-market fit with tactical capital. You find scale with distribution capital.
Product-market fit is the process of finding hype. When you stop pushing and start finding the pull in the market. Scale is the process of manufacturing hype.
The bear case
But there are downsides to hype. Last month, Nikhil, founding partner at Footwork, put it better than I ever could.
If I could add an 8th point to Nikhil’s analysis, it’d be that investors in today’s market are incentivized to “pump and dump” their investments. Early stage investors spike up the valuations, which leads to downstream investors like Tiger Global, Coatue, Insight, and Softbank doubling down on valuation bets. Once there’s a secondary market for private shares, early stage investors then liquidate their equity to growth investors who are seeking ownership targets, or just to get a slice of the pie. This creates an ecosystem of misaligned incentives, where early stage investors are no longer in it for the long run with founders. Great fund strategy that’ll make LPs happy campers, but it leaves founders with uncommitted, temporary partners.
Sundeep Peechu of Felicis Ventures has an amazing thread on how getting the right founder-investor fit right is a huge value add. And getting founder-investor fit takes time, and sometimes a trial by fire as well. After all, it’s a long-term marriage, rather than a one-night stand. Those who don’t spend enough time “dating” before “marriage” may find a rocky road ahead when things go south.
By my count, ~30% of Felicis companies that have done well had trouble raising Series As in some fashion.
As an example, Matterport which went public last week had little appetite at the A. Non-recurring revenue, hardware business and selling to real estate was a triple whammy.
On a 9th point, underrepresented and underestimated founders are often swept under the rug. In a hype market, VCs are forced to make faster decisions, partly due to FOMO. With faster decisions, investors do less diligence before investing. Which to the earlier point of misaligned incentives, has amplified the already-existing notion of buyer’s remorse.
When VCs go back to habits of pattern recognition, they optimize for founder/startup traits they are already familiar with. And often times, their investment track record don’t include underrepresented populations. To play devil’s advocate, the good news is that there is also a simultaneous, but comparatively slow proliferation of diverse fund managers, who are more likely to take a deeper look at the problems that underestimated founders are tackling.
What kind of curve are we on?
When many others seem to think that this hype market will end soon, last week, I heard a very interesting take on the current venture market in a chat with Frank Wang, investor at Dell Technologies Capital. “VCs have been mispricing companies. We anchor ourselves on historical valuations. But these anchors could be wrong.
“We’re at the beginning of the hype and I don’t see it slowing down. VC has been so stagnant, and there hasn’t been any innovation in venture in a long time. Growth hasn’t slowed. And Tiger [Global] and Insight [Partners] is doing venture right. Hypothetically speaking, if you invest in everything, the IRR should be zero. They are returning 20% IRR because they seem to have found that VC rounds are mispriced. So, there can be an arbitrage.
“There will be a 20% market correction in the future, but we don’t know if that’s going to happen after 100% growth, or correct then grow again. The current hype is just another set of growing pains.”
Part of me is scared for the market correction. When many founders will be forced to raise flat or down rounds. The fact is we haven’t had a serious market correction since 2009. It’s going to happen. It’s not a question of “if” but rather “when” and “how much”, as Frank acutely points out.
Investors who deploy capital fast win on growing markets – on bull markets. Or investors who deploy across several years, or what the afore-mentioned Mark Suster defines as having “time diversity“, who win on correcting markets – bear markets. Think of the former as putting all your eggs in one basket. And if it’s the winning basket, you’re seen as an oracle. If not, well, you disappear into obscurity. Think of the latter as diversifying your risk appetite – a hedging strategy. More specifically, (1) being able to dollar-cost average, and (2) having exposure to multiple emerging trends and platforms. You’re not gonna lose massive amounts of capital even in a bear market, but you also will be losing out on the outsized returns on a bull market.
Only time will tell how seriously the market will correct and when. As well as who the “oracles” are.
In closing
At the end of the day, there are really smart capital allocators arguing for both sides of the hype market. Like with all progress, the windshield is often cloudier and more muddled than the rearview mirror. As Tim Urban once wrote, “You have to remember something about what it’s like to stand on a time graph: you can’t see what’s to your right.“
And as founders are going to some great term sheets from amazing investors, I love the way Ashmeet Sidana of Engineering Capitalframes it earlier this year. “A company’s success makes a VC’s reputation; a VC’s success does not make a company’s reputation. In other words to take a concrete example, Google is a great company. Google is not a great company because Sequoia invested in them. Sequoia is a great venture firm because they invested in Google.”
Whether you, the founder, can live up to the hype or not depends on your ability to find distribution before your competitors do and before your incumbents find innovation. Unfortunately, great investors might help you get there with capital, but having them on your cap table doesn’t guarantee success.
Nevertheless, the interpretation of hype is always an interesting one. There will continue to be debates if a market, product, or trend is overhyped or underhyped. The former assumes that we are on track for a near-term logarithmic curve. The latter assumes an immediate future looking like an exponential curve. The interpretation is, in many ways, a Rorschach test of our perception of the future.
Over the course of human civilization, rather than an absolutely smooth distribution, we live something closer to what Tim Urban describes as:
If the regression line is the mean, then we’d see the ebbs and flows of hype looking something like a sinusoidal function. As Mark Twain once said, “History doesn’t repeat itself, but it often rhymes.”
It won’t be a smooth ride. The world never is. But that’s what makes the now worth living through.
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I was introduced to a founder of an e-commerce marketplace recently trying to figure out what product-market fit looks like. Specifically what might be some early tells of PMF. And I told him, “If your users are sticking around long enough to try to game your system, you have something they want. While it might not be in the most efficient format, you’re close to PMF. Subsequently, solving that frictional point that users are trying to ‘hack’ will delight them.”
Last year, I wrote that one of the tells of a great unicorn idea is frustration with the status quo. And the lagging indicators of frustration are complaints, but even better, “hacks”. Life hacks. Career hacks. Cold email hacks. Any time a forum or community comes together to share best practices is a potential market opportunity. As Jeff Bezos once said, “Your margin is my opportunity.”
Similarly, if some of your users converge around circumventing your platform, they’re hacking their way to find a better solution. But the fact they’re sticking around on your platform means you have something they want. And while it could be more elegant, you’ve solved the rocks of the “rocks, sand, and water” framework. What’s left are the “sand” and the “water”. And they come disguised as a user hack.
Sarah Tavel of Benchmark once wrote: “You must create an offering that is so compelling, it stands by itself in the consumer’s mind.” Solving all the frictional points in the user journey will get you to that compelling offering – a lovable product.
A reader reached out to me last year and said, “Thank you… [But] you have no idea how long I spend reading your blogposts with a dictionary next to me.” While it wasn’t necessarily a hack, to know there was a reader out there willing to weather through my idiosyncratic vocabulary in my earlier essays meant a million to me. But at the same time, it was a sign I was too caught up in my own wordsmithing. So, I dialed it back. While there will still be some esoteric jargon from time to time, I try to make my writing more relatable when editing. And to that reader… if you’re still reading this essay, thank you.
Back in 2007, Marc Andreessenwrote: “The market pulls product out of the startup.” In this case, that pull becomes a race between you and your users’ frustration. Can you release an update that addresses your users’ pain point before they become so frustrated they pack up and go? Either to build their own version or try a competitor’s.
I love Max Nussenbaum of On Deck’s analogy here. “If the market is indeed pulling the product out of you, you sometimes feel less like a creator and more like a mere conduit.” You, as the team behind the product, are a conduit to satisfying your users’ needs. As Mike Maples Jr.says, “Getting storytelling right means the founder is the mentor of the story (ie Yoda), rather than the hero (ie Luke.).” Your customers are the heroes of the story. Of their story. And your story. How they spend their time should offer you brilliant product insights.
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A number of founders ask me for fundraising advice. While they come in different magnitudes, one of the common themes is: “I’ve had many investor meetings, but I still can’t get a term sheet. What am I doing wrong? What do I need to do or to say to get a yes?”
To preface, I don’t have the one-size-fit-all solution. Neither do I think there is a one-size-fit-all solution. Each investor is looking for something different. And while theses often rhyme, the “A-ha!” moment for each investor is a culmination of their own professional and life experiences. This anecdote is, by no means, prescriptive, but another perspective that may help you when fundraising, if you’re not getting the results you want. This won’t help you cheat the system. If you still have a shoddy product or an unambitious team, you’re still probably not going to get any external capital.
One thing I learned when I was on the operating side of the table is: When you want money, ask for advice. When you want advice, ask for money. It’s, admittedly, a slightly roundabout way to get:
Investor interest,
And reference points for milestones to hit.
But it’s worked for me. Why? Because you’re fighting in a highly-competitive, heavily-saturated market of attention – investor attention. This method merely helps you increase the potential surface area of interaction and visibility, to give you time in front of an investor to prove yourself.
Investors are expected to jump into a long term marriage with founders, while, for the most part, only given a small cross-section in your founding journey to evaluate you. It’s as if you chose to marry someone for life you’ve only met 60-90 days ago. While angels and some people have the courage and the conviction to do that, most investors like to err on the side of caution. Contrary to popular belief, venture capitalists are extremely risk-averse. They look for risk-adjusted bets. And if you can prove to them – either through traction or an earned secret – that you’re not just a rounding error, you’ll make their lives a lot easier.
So, let me elaborate.
When you want money, ask for advice.
As you’re growing your business and you want to show you are, ask investors for advice. Tell them. “So I’ve been growing at X% MoM, and I’ve gotten to Y # of users. I’m thinking about pursuing this Z as my next priority. And this is how I plan to A/B test it. What do you think?”
And if you keep these investors in the loop the entire time and ask and follow-up on their advice, at some point, they’d think and ask, “Damn, this is an epic business. Will you just take my money?”
So, what are good numbers?
The Rule of 40 is a rough rule of thumb many investors use for consumer tech markets. Month-over-month growth rate plus profit should be greater than or equal to 40. So you can be growing 50% MoM, but burning money with -10% profit, aka costs are greater than your revenue. Or you can be growing 30% MoM, but gaining 10% profit every month. And if you’ve got 10s of 1000s of users, you’re on solid ground. Better yet, one of the biggest expenses is increasing server capacity costs.
For more reference points on ideal consumer startup numbers, check out this blog post I wrote last year.
For enterprise/B2B SaaS, somewhere along the lines of 10-15% MoM growth. With at least 1 key customer logo. And 5 publicly referenceable customers.
Of course, the Rule of 40 did not age well for certain industries in 2020.
When you want advice, ask for money.
When you ask for money most of the time, investors, partners, and potential customers will say no, especially if you’re super early on and don’t have a background or track record as an entrepreneur. So when they do say no, I like to ask them one of my favorite questions: “What do I need to bring you for you to unconditionally say yes?” Then, they’ll tell me what they want to see out of our product or our business. These, especially if they’re reinforced independently across multiple different individuals in your ecosystem, should be your North Star metrics. And when you do put their advice to action, be sure to follow up with the results to their implemented advice.
You either do what they recommended. And show them what happened. And what’s next.
Or you don’t do what they recommended. But show that you heavily considered their recommendation. What you did instead. Why you chose to do what you did instead. And what’s next.
To take it one step further, once I ask the above question to have a reference point for growth trajectory, I ask: “Who is the smartest person(s) known to achieve X (or in Y)?” with X being the answer you got via the previous question. And Y being the industry you’re tackling.
Then, go to that person or those people and say, “Hey Jennifer, [investor name] said if there’s one person I had to talk to about X, I have to talk to you.” Feel free to use my cold email “template” as reference, if you’re unsure of what else to say.
If you use this tactic again and again, eventually you’ll build a family of unofficial (maybe even official) mentors and advisors, even if you never explicitly call them that. Not necessarily asking for money all the time. But asking for money might help you ignite the spark for this positive feedback loop.
In closing
When I was on the operating side, a brilliant founder with 2 multi-million dollar exits once told me: “Always be selling. Always be fundraising. And always be hiring.”
I didn’t really get it then. In fact, I didn’t get it the entire time I was on the other side of the table. What do you mean “Always be fundraising”? Should I just be asking for money all the time? What about the business?
It wasn’t until I made my way into VC at SkyDeck that I realized the depth of his words. Keep people you eventually want to fundraise from and hire in the loop about what you’re building. Keep them excited. Build a relationship beyond something transactional. Build a friendship.
Jeff Bezos put it best when he said:
“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.
“At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow and we’re very stubborn. We say we’re stubborn on vision and flexible on details.”
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While sipping on my morning green tea, I’m inspired by Venture Stories’ recent podcast episode where Erik was interviewing Charles Hudson of Precursor, where they codify Charles’ investment thesis, markets, business models, among many other topics. A brilliant episode, if I say so myself! And it got me thinking.
Some market context
In the past few months, I’ve been chatting with a number of founders who largely seem to gravitate towards the subscription business model. Even pre-COVID, that seemed to be the case. And this notion was and is further perpetuated where a plethora of VCs turned their attention to XaaS (X-as-a-service).
Why? Pre-COVID, the general understanding was that consumers were:
More expensive to acquire,
And, harder to retain,
…which I shared in one of my February posts. I’d even heard some investors say: “Consumer social is dead.” Although I personally didn’t go as far as to illustrate the death of a vertical, I had become relatively more bearish on consumer than I did when I started in venture. Clearly, we were wrong. The question is: how much of this current situation will still hold true post-COVID? And honestly, your guess is as good as mine. But I digress.
Given the presumption that the consumer industry was faltering, many VCs re-positioned their theses to index more on enterprise and SaaS models. Models that had relatively fixed distribution channels and recurring revenue. It became some form of ‘guarantee’ that their investments could make their returns. And as the demand for startups shifted, supply followed.
The Business Models
Though there seemingly has been an overindexing of subscription models in the consumer space, I’m still an optimist for its future. The important part is to follow consumer behavior.
What do their consumption patterns look like?
What do their purchasing patterns look like?
How do customers think about value?
Here is a set of lens in which I think about business model application:
Subscription
“One-off”
Continuous consumption patterns >3-4 times in a month (Ideally, >3-4 times per week)
Discrete consumption patterns ~1-2 times a year Extremely episodic in nature
Proactive, expectant behavior
Reactive behavior
Examples: Food Groceries Music Education
Examples: Moving homes One-off Conferences Travel Car
Note: The examples are generalized. The business models will depend on your target market. For example, travel for the average family may not happen on a recurring basis, but travel for a consultant happen weekly (pre-COVID).
The Extremes of Gross Margins
Of course, I can’t talk about business models without talking about profits. The ultimate goal of any business model is to realize returns – gross margins. Unfortunately, there’s no silver bullet on how you price your product. While you find the optimum price (range) for your product A/B testing with your customers, here’s a little perspective onto the two extremes of the spectrum.
If you have insanelyhigh margins, expect lots of competitors – either now or in the near future. Expect price-based competition, as you may most likely, fight in a race to the bottom. Much like the 1848 California Gold Rush. Competitors are going to rush in to saturate the market and squeeze the margins out of “such a great opportunity”.
If your margins are incredibly low, as Charles said on the podcast, “there better be a pot of gold at the end of the rainbow.” You need extremely high volumes (i.e. GMV, “liquidity” in a marketplace) to compensate for the minimal cut you’re taking each transaction. A fight to monopolize the market. I’m looking for market traits like:
Growing market size.
Ideally heavily fragmented market where you can capture convoluted, antiquated, and/or unconcentrated processes in the status quo.
Why unconcentrated? Don’t underestimate the power of your incumbents’ brands and product offerings. Like don’t jump in ad tech if you’re just going to fight against the Google and Facebook juggernauts, who own 80% of the ad market.
For example, payments or food delivery. Food delivery is one where you have to reach critical mass before focusing on cash flow/profitability. I get it. It’s a money-eating business… until network effects kick in. Sarah Tavel wrote a Medium article about this where she explains it more elegantly than I have.
In closing
I’ve seen many founders end up taking their models for granted or sticking to a single generic revenue structure. But the best founders I meet make this a very intentional part of their business. Sometimes, even having different revenue streams for different parts of the business. If that’s the case for you too, Connie’s piece about multimodal models may be worth a read.
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I have a love-hate relationship with that word. On one hand, I love and seek to learn from creative souls. It’s a trait that I seriously respect in individuals, regardless of industry, profession, or background. On the other hand, it’s rather amorphous. What’s creative to me may not be creative to you. We are bounded by the parameters of our experiences and what we, as individuals, are exposed to.
So, where do innovators draw inspiration?
Over the years, I’ve seen inspiration stem from three main frameworks:
The flow from art;
Margins;
And, what people dislike.
The Flow from Art
I seem to find that the data largely (with a few outliers) points towards the following:
Art precedes science. Science precedes tech. Tech precedes business. Business precedes law.
Art is bounded only by one’s imagination. Science, which draws inspiration from art, is limited by our physical universe and the fundamental laws. And, tech rides on the coattails of science, restricted by the patterns recognized in our universe by scientists before them. Similarly, business can only optimize existing technology. Following suit, regulations and legal practice can only debate and prevent ramifications that have turned from hypothesis to reality.
On one end of the spectrum, fiction has driven innovation on the fundamental, scientific front. Scientists have tried to make the impossible – fiction, superstition, assumptions, and imagination – possible. On the other end, the legal and regulatory space has empirically lagged behind business innovation. From autonomous driving to the shared economy to video games, a regulatory emphasis came only after incidents occurred. I’m a huge proponent of founders becoming self-regulatory. But that is a discussion for another day.
Margins
As Jeff Bezos famously said:
“Your margin is my opportunity.”
In the lens of a businessperson, profits exist on the margins. In a fully saturated market, as we learned in economics class, perfect competition will squeeze out profits. That margin can be delta between human perfection and imperfection. It can be the difference between a naive and sophisticated individual. It can also be the blind spots between a self-awareness and ignorance.
The good news (and bad news?) is that humans aren’t rational. As much as we try to be, we’re not. We repeat the same mistakes. After all, that’s where our favorite stories come from – the fact that we’re imperfect. If we were rational, our friendly neighborhood kid from Queens wouldn’t have to struggle with identity. Or, Skinner, the head chef at Auguste Gusteau’s restaurant, wouldn’t be out to exterminate my favorite rat chef.
From a nonfictional front, if we were rational, gambling, the lottery, therapy, and more wouldn’t exist. In fact, there’s a whole industry that capitalizes on human imperfection – insurance. We choose to reach for that last cookie when we know a healthier diet with less sugar is better for us (I’m guilty as well). We set New Year’s resolutions to work out more, but regress to our couch norm after the first month. Walter Mischel famously conducted The Marshmallow Experiment. When given the option to wait 15 minutes to double their treats, many children opted for immediate gratification.
There would be way fewer founders if they were rational. I mean, come on, the numbers work against them. 90% of startups fail. So, from a VC’s perspective, we have to ask ourselves:
What’s is the underlying notion that makes this product work?
What is that innate theme in human or societal development that won’t disappear anytime soon? What factors produce such a trend? And what margin is it taking advantage of? Uber was made possible with the evolution of smartphone and faster data. As more data were archived online, Google became a reality because of the internet and browser. Two current examples of underlying notions include:
Audio, including, but not limited to, podcasts and audiobooks, is the new form of content consumption. Not only does it free up consumers’ hands and eyes up, audio content is often easier to digest. The spoken word has been around millennia, whereas print is fairly new invention. Emotions and sarcasm is often easier to relay via audio than via print. So, what else is possible?
With growing consumer sentiment against traditional social media, like Facebook, Twitter, and Instagram, there is a shift to social experiences surrounding active participation. Sarah Tavel writes a great piece on this. Examples include Discord, Medium, TikTok, and user-generated content (UGC) in video games, like mods and in-game skins. Many of the traditional social media platforms leave users with a more negative passive experience, where they feel a sense of FOMO (fear of missing out). Through active participation, users can be a part of the conversation, rather than watch from the sidelines.
What do you dislike?
Speaking of negative experiences, aversion is a strong motivating emotion humans have. Like prospect theory illustrates, loss invokes a stronger response than gains. It also happens to be one of the reasons why I probe how obsessed a founder is about a certain problem.
In a recent interview with Andrew “Kappy” Kaplan, host of the podcast, Beyond the Plate, Grant Achatz, legendary chef, talks briefly about how he drew inspiration from his daughter’s dislike of cheese, yet she still ate pizza and grilled cheese sandwiches. Similarly, when his guests at Alinea didn’t like sea urchin, he thought about the ‘why’ and if he could circumvent their aversion by playing with various variables, including iodine concentration.
So, what do you dislike (with a passion)? What about the people around you? And can you figure out a way to change or eliminate that frustration? Take some time through the idea maze.
In closing
Ideas come in all shapes and sizes. Some may be more obvious than others. Some may snowball into a best-selling one. Although I’ve shared the three most common frameworks that I’ve personally generated and seen others find inspiration, it is, of course, not the only ways to exercise your creative muscle. In fact, the first step into being more “creative” is being cognizant about everything around you.
Two years ago, one of my former professors recommended I start ‘idea-journaling’ every day. Since I’ve started, I began noticing more and more stimuli from my surroundings, conversations and frustrations.
It may be a start, but it’s by no means an end. Stay curious.
