We all know to pay attention to the different reasons that a business may not succeed. If you ignore the risks, you might fail before you even get started. In my opinion, however, the most important question to ask when assessing a seed investment is less obvious. How significant an impact would this startup have if it succeeded?
A venture capital portfolio works a lot like a barn full of racehorses — for every highly visible Kentucky Derby winner, the trainer has a bunch of modestly successful (and unsuccessful) runners back in the barn. The reason this works, in both racehorses and venture capital, is the extreme asymmetric returns of successful investments. In other words, on any specific investment, I know at the outset that, if the startup fails, I could lose up to the amount of money I have invested. To make that risk worth it, I have to project the investment returning much more than 10x the amount invested if ultimately successful.
Birchmere has an almost 20-year history of delivering top decile returns among all venture investors. This success is primarily driven by our most successful investments. For example, my Birchmere partner Sean Sebastian was the first institutional investor in FreeMarkets, which remains to this day the second largest IPO in the history of the NASDAQ.
In 2000, Birchmere led the Series A financing in Cvent, which had a very successful IPO in 2013 and was later taken private by Vista Equity Partners for $1.65 billion. My partner Ned Renzi, who led the investment and sat on Cvent’s board, tells the story with this caveat for entrepreneurs: “it took over 10 years for Cvent to be an overnight success”. Cvent demonstrated amazing perseverance and ability to overcome obstacles by a talented group of entrepreneurs. ultimately delivering a fantastic result for investors in a time period when almost no one made money in venture (the “dot com bubble”). (Learn more about the Cvent story and other successful ventures in my book The Science of Growth.)
Birchmere is not unique in how much of our returns are driven by investments in our two unicorns from our roughly 50 investments over the last two decades. As I’ve spent time with other venture capitalists, I’ve come to appreciate that most early stage funds depend on a select one or two investments per portfolio that deliver most of their financial performance.
When I assess a seed investment, I want to make sure that it has the potential to deliver breakout results if successful. That doesn’t mean that a company without that potential is a bad business. It may be a great company — Just not a company against which I would choose to deploy my investors’ capital.
When I ask this question, I am intentionally not asking it in a way that would get me their financial projections (we’ll get to that later). I want to know “what the world looks like.” Great entrepreneurs create the world the way it ought to be, and I have discovered that an entrepreneur’s passion comes through when they tell me first about the problem they are solving, then how that will deliver value to their customers and, ultimately, their business.
While this conversation does ultimately lead to some estimation of the total addressable market, I think that starting with the question framed this way avoids the mistakes many outsiders make when trying to estimate a market size too precisely early in a company’s development. For more on this, I recommend reading Bill Gurley’s post: How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size
This is the first of five posts I plan to write on key questions I ask seed investments. You can read an overview of the series here.
