One of the most interesting self-reflective questions I think GPs should ask is: If someone else had the exact same strategy and offered the exact same terms, why would someone not pick you over another VC? That’s adverse selection.
One of the three pillars (or five pillars, depending on who you ask) of underwriting a venture fund is winning. The others being seeing and picking (and supporting and selling). But sometimes what’s more interesting than underwriting why a GP wins is understanding all the reasons they won’t win.
It’s an interesting thought exercise I like working through with a GP. “Why won’t a founder let you invest?” or “Assuming you wanted to invest, why would you lose out on a deal?”
The most common answers are always:
- “I missed the timing.”
- “There was no more space left.”
- “They weren’t raising at the time.”
In my opinion, while possibly true, all cop-out answers. Then I follow up: “Assuming you wanted to invest, and there’s space left, and they’re currently raising, why would a founder say no to you?” Or “Why wouldn’t you be able to invest?” More often than not, I get an answer along the lines of: “I win (almost) every deal I want.” Or “I have yet to raise my fund.”
Even if true historically, it doesn’t answer the question. It’s like asking a job candidate: “Tell me about your weakness.” And they respond with, “I’m too honest.” Or worse, “I have no weaknesses.”
What I’m trying to get at in these questions is not the “right” answer. There is none. But rather what are the reasons you’ll fail to win a deal. Which of those reasons are areas where you would like to improve upon? Which of those reasons are areas where you will continue to be unrelenting on? What will you not change? Only then can I get a better understanding of the GP you will become 2-3 funds from now. And if so, does it make sense to do business with each other today?
There’s a Fund I GP I ended up investing in. When I first asked him the question above, he reached the conclusion that his pitch and value-add resonated more with second-time founders than first-time founders at the pre-seed stage. And given that he wanted to grow into a lead investor eventually, what he had to figure out was how to build a strong enough brand with first-time founders, requiring both education and intentional positioning. For me as an LP, it became easy for me to see how he would grow into a Fund II GP. Between then and his next fundraise, I’d just track how many first-time founders he invested in, try to spend time with them at events, and ask why did you take this GP’s check and what did you really want from him.
There is no right answer as to what founders wouldn’t want to work with you. It’s just an exercise of self-awareness, so you can figure out what’s worth working on and what’s not. Adverse selection reasons I’ve heard in the past, in no particular order, include:
- Political alignment
- Naming a firm after their own name instead of an ideal (yes, that is a real answer I’ve gotten before)
- Speed to make a decision
- High ownership targets
- Response time, including taking the holidays/weekends off when their peers might still be dealmaking
- Lack of brand awareness
- No founding experience
- No experience at a large established firm
- No relationships with key potential customers
- Values shared publicly / controversial opinions
- Personality (i.e. too nice, people pleaser, argumentative, arrogant, name-dropping/logo-shopping, too humble, etc.)
- Lack of talent networks
- Having invested in a competitor
- A homogenous partnership
- A rumor that is widespread but may not have real credence
- A single remark from an influencer in the ecosystem (or a close friend), then what’s more interesting is why someone would say something like that
- The way a GP dresses (especially important in certain geographies outside of the US)
- The initial outreach was done by a junior team member or a broker/dealer
- Subsequent conversations done by a junior team member
- A reference call with their network done in poor taste
- Someone with no board experience asking for a board seat
- Having someone else on the team take the board seat even though you did the deal and the founder wanted you
- Aggressive term sheet terms (1X+ liquidation preferences – participating and preferred)
- Having no respect for prior round investors (especially, in relation to their most helpful investors so far, often related to their pro rata)
- Badmouthing their existing investors and/or teammates
Photo by Javier Allegue Barros on Unsplash
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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.