“Readily available quantitative information about the present is not gonna give you they key to the castle. […] If everyone has all the company data today and the means to massage it, how do you get a knowledge advantage?
“The answer is you have to either:
- Somehow do a better job of massaging the current data, which is challenging; or you have to
- Be better at making qualitative judgments; or you have to
- Be better at figuring out what the future holds.”
Those are the words of the great Howard Marks on a recent Acquired episode.
When most of us first learned economics — be it in high school or college, we learned of the Efficient Market Hypothesis. In short, if you had access to both public and private information, you would be capable of generating outsized returns that outperformed the market.
The truth is that reality differs quite a bit. And that’s especially in early-stage investing. Investors often make investment decisions with both public and private information at their disposal. There is admittedly still some level of asymmetric information, but that depends on deep of a diligence the investors do. Yet despite the closest thing to a strong efficiency, there’s still a large delta between the top half and bottom half of investors. The gap widens further when you compare with the top quartile. And the top decile. And the top percentile. Truly a power law distribution.
Massaging the data
I’m no data scientist, although I am obsessed with data. But there are people who are, and among them, people I deeply respect for their opinion.
There’s been this relentless, possibly ill-placed focus on growth (at all costs) over the last two years. Oftentimes, not even revenue growth, but for consumer startups, user growth.
I want to say I first heard of this from a Garry Tan video. The job of a founder pre-product-market fit (pre-PMF) is to catch lightning in a bottle. The job post-PMF is to keep lightning in that bottle. Two different problems. Many founders ended up focusing on or were forced to focus on (as a function of taking venture money) scale before they caught lightning in that bottle. They spent less time on A/B testing to find a global maximum, and ended up optimizing for a local maximum.
Today, or at least as of September 2022, there’s this ‘new’ focus on retention and profitability (at all costs). But there’s no one-size-fit-all for startups. As a founder, you need to find the metric that you should be optimizing for — a sign that your customers love your product. Whether it’s the percent of your customers that submit bug reports and still use your product or if you’re a marketplace, the percent of demand that converts to supply. Feel free to be creative. Massage your data, but it still has to make sense.
From a fund perspective, equally so, it’s not always about TVPI, IRR, and DPI, especially if you’re an emerging fund manager. Or in other words, a fund manager who has yet to hit product-market fit. You probably have an inflated total-value-to-paid-in capital (TVPI) — largely, if not completely dominated by unrealized return. The same is true for your IRR as well. In the past two years, with inflated rounds and fast deployment schedules, everyone seems like a genius. So many investors — angels, syndicate leads, and fund managers — found themselves with IRRs north of 70% for any vintage of investments 2019 and after. Although an institutional LP that I was chatting with recently discounts any vintage of startups 2017 and after.
So the North Star metrics here, for fund managers, isn’t IRR or TVPI. It’s other sets of data. I’ll give two examples. For a fund manager I chatted with a few weeks ago, it was the percent of his portfolio that raised follow-on capital within 24 months of his investment because it was more than twice as great as the some of the best venture firms out there. Another fund manager cited the number of his LPs who invested in his fund’s pro rata rights through SPVs.
Making qualitative judgments
In this camp, these are folks who have an extremely strong sense of logic and reasoning. When a founder has yet the data to back it up, these investors go back to first principles.
In my experience, these investors are incredible at asking questions, like how Doug Leone asks a founder for their strengths and weaknesses. But more than just asking questions, it’s also about building frameworks and knowing what to look for when you ask said questions.
For instance, every investor knows grit is an important trait in a founder. More than knowing at a high level that grit is important, what can you do to find it out? For me, it boils down to two things.
- Past performance. In other words, prior examples of excellence that they worked hard to get.
- Future predictors. I ask: Why does this problem keep you up at night? Or some variation. Why does this problem mean so much to you? Why are you obsessed? Are you obsessed? Why is this your life’s calling? And I’m not looking for a market-sizing exercise here.
While I don’t claim to hold all the truths in this world, nor can I yet count myself in the highest echelons of startup investing, the most I can do here is share my own qualitative frameworks for thinking:
- Breaking down intuition into five senses
- What ‘signal’ means to me outside of co-investors, traction and an experienced team
Futurists
One of my favorite thought pieces on the internet is written by a legendary investor, Mike Maples Jr. of Floodgate fame. In it, he illuminates a concept he calls “backcasting.” To quote him:
“Legendary builders, therefore, must stand in the future and pull the present from the current reality to the future of their design. People living in the present usually dislike breakthrough ideas when they first hear about them. They have no context for what will be radically different in the future. So an important additional job of the builder is to persuade early like-minded people to join a new movement.”
Early-stage investors must have the same genetics: the ability to see the future for what it is before the rest of humanity can. And they back founders who are capable of willing the future into existence and create reality distortion fields, a term popularized by Bud Tribble when describing Steve Jobs.
When I first jumped into venture, one of the first VCs I met — in hindsight, a futurist — told me, “Some of the best ideas seem crazy at first.” A visionary investor is willing to take the time to detect brilliance in craziness. Paul Graham, in a piece titled Crazy New Ideas, proposed that it’s worth taking time to listen to someone who sounds crazy, but known to be otherwise, reasonable because more than anyone else, they know they sound crazy and are willing to risk their carefully-built reputation to do so.
For 10x founders and investors alike, the more you hear them out, the more they make sense. That said, if they start making less and less sense the more you listen, then your time is most likely better spent elsewhere.
In closing
As you may already know, a great early-stage investor requires a different skillset than a great public equities trader or a hedge fund investor. You’re more likely to work with qualitative data than quantitative data. Regardless of what archetype of a venture investor you are, you have to believe that we are capable of reaching a better future than the one we live in today. It is then a question of when and how, not if.
Of course, I don’t believe that these three archetypes are mutually exclusive. They are more representative of spectrums rather than definitive traits. Think of it more like an OCEAN personality test than a Myers-Briggs 16 personalities.
To sum it all, I like the way my friend describes venture investors: pragmatic optimists. Balance the realities of today with how great the future can be.
Photo by Jordan Madrid on Unsplash
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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.
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