Venture Investor’s Playbook: Part 4

The “SSWISH” Cycle: Seeing and Selecting

Chip Hazard; General Partner, Flybridge

This post is Part 4 of a series on Chip’s Playbook of 4 Success Factors for Early-Stage Venture Investors. You can see Parts 1, 2, and 3 here:

Part 1: Introducing the 4 Success Factors
Part 2: The Power-Law of Venture Returns
Part 3: Identifying and Capitalizing on Macro Market Trends

So far, we’ve discussed the importance of investing behind outliers —companies that can return 50x, 100x, or even higher returns on your invested capital. We also discussed how this is easier if you’re on the right side of significant trends, as catching a new trend early can give your portfolio some extra oomph in the market.

So how does a seed-stage investor make 50x or higher potential investments? Let’s start by considering the venture process:

See → Select → Win → (Invest) → Support → Harvest

This process, which I call SSWISH (as in Steph Curry or Breanna Stewart nailing a three-point shot) is self-explanatory. You meet with the founders of a potential investment (See), decide if you want to invest (Select), convince the founder to take your investment (Win), close the investment (Invest), and once involved, focus on the most critical issues and opportunities to drive success (Support), then ultimately exit the investment (Harvest).

Beyond this simple left to right SSWISH flow, there is also a recursive nature to the cycle. For example, what you see should be informed in part by your selection biases; what you see is a function of the other companies in which you have invested; how you win is often a function of how you help; and big wins tend to make you a preferred partner for new companies, which means you see more companies. Let’s explore each step in the flow and the interrelationships of each stage.

Any venture capitalist is only as good as their deal flow. This is for two reasons: the first, obvious one, being that if you don’t see Facebook as an early investment opportunity (raises hand), you don’t have the chance to invest, and the second, less obvious one is that you become a better investor the more deals you see.

Some people think you can rifle-shot investments, but I believe a broader perspective is important.

It makes you aware of a range of opportunities, and, as we discussed in the post on market trends, it makes you a more informed investor. The second reason is that seeing more opportunities helps you develop a clearer sense of what you specifically like. In other words, if you see ten companies and select the one you think is the best, that one may not rank in the top third of potential opportunities if you were to see a 100 new companies.

Over and over again, I’ve heard from new investors that, in hindsight, their first investment isn’t one they would have made if they saw the company six or twelve months later after reviewing dozens of other opportunities.

So how does one address the first-order question of seeing investment opportunities? There are some clear steps:

• Make sure your personal network knows you’re actively interested in investing.
• Let other angels and seed investors know that you’re investing.
• Attend conferences and meet-ups where early-stage founders congregate.
• Ask anyone you know in the opportunity flow about founders who are starting something new.
• It also helps to be proactive: reach out to founders working in interesting fields, connect with early executives at high-profile companies that could be future founders, and track teams post acquisitions who might be looking to start another company.

It’s ultimately a grassroots, networked-based business in many dimensions, which of course you can augment with social channels and other ways to more broadly communicate your perspectives, insights, and personal areas of focus.

It also helps to have a clear point of view on where you think you have a competitive sourcing advantage. For our team at XFactor Ventures, our edge is obvious given the focus on companies with female founders and the relative dearth of VC funds pursuing that target segment. As another example, for my Flybridge partner Jesse, it’s his experience as a member of the founding team at WeWork that developed insights into how to build community-driven businesses as well as connections into the ranks of former co-workers and business partners he met while doing so. For others, it could come about as a result of a reputation for expertise in specific domains.

Additionally, it’s important to be able to describe succinctly what you’re looking for. Venture investors are notorious for saying “let’s share deal flow” or “love to hear about any founders starting companies in your network” to other investors or founder friends, but these offers are too generic to activate any meaningful connections. It helps to be more specific. Examples of what we say from the two funds I’m involved with are:

XFactor Ventures: “We’re looking to be the first check for companies with female founders going after billion-dollar opportunities, so if you know any badass female founders in your network starting companies, send them to us. We make quick decisions and leverage the collective networks of our 23 investment partners, all of whom are female founders themselves, to help on strategy, leadership development, and connections to customers, partners, and other potential investors. Across our team, we have expertise ranging from consumer, consumer tech, marketplaces, B2B SaaS, AI, frontier tech, healthcare tech, fin-tech, and agtech.”

Flybridge: “We’re first institutional investors for tech and community-driven companies in the Northeast, leading pre-seed, seed, and small Series A rounds. Leveraging our collective expertise as founders and investors over the last couple of decades, we partner closely with founders to help them build a foundation for success.”

Lastly, it helps to leverage your market insights to be highly thematic. If you share deep insights with your network and founders into a given trend or market need and communicate a clear point of view on where opportunities lie, what factors contribute to success, and what common challenges impact a given area, it creates the opportunity to demonstrate expertise and passion — and to be very specific and focused from a sourcing perspective. It also helps in the selection process as you’re approaching a new potential investment with an informed opinion as to what will make for an excellent opportunity.

Simplistically, most investment decisions fall into being driven by the team, market opportunity, product/tech/business-model, or some combination of all three. Highly successful investors have differing points of view on the relative importance of each, so it’s worth thinking about what is personally motivating for you while recognizing the advantage of seeing an exceptional opportunity on multiple dimensions. To the extent these are competing philosophies, they can be summarized as follows:

• Team-biased investors believe the initial idea is likely going to morph and change multiple times, so what’s most important is to back exceptional people (often who have a proven track record) with tremendous grit and drive who will listen to the market, iterate their way to success, and be adept leaders.
• Market-biased investors believe that the fishing pond in which a company is operating is the most important thing, and that when a market is growing rapidly and has the potential to become huge, it not only covers up lots of sins in terms of execution but also allows companies to have a huge competitive advantage in attracting talent and raising capital, which helps drive the business forward more quickly. As the old saying goes, “When a great team meets a bad market, the market wins.”
• Product/tech/business model biased investors believe that investing in things that are really hard to build, much better than the status quo or competing alternatives, have the potential for network effects, are deeply disruptive, and will drive both competitive barriers to entry, growth, and adoption, is the most critical selection criteria.

Again, to characterize these as competing outlooks is too simplistic. If you look back on highly successful investments, they all have some of each component for success.

For example, our investment in MongoDB was predicated upon a fabulous technical team, going after a massive market, with a highly compelling and disruptive product. Outside of our portfolio, WhatsApp was a highly capable technical team with something to prove and a ton of grit, a massive market of anyone in the world with a mobile phone, and a product that was wildly easy to use, inherently viral, and much better than the status quo of SMS texting, (particularly in less developed markets). This article from Ali Tamaseb of DCVC has some interesting data on the characteristics of outliers, which reinforces the point that there are numerous contributing factors.

One possible framework to think about for selection is the one we use at Flybridge when we’re considering a new early-stage investment:

Team

What makes this team exceptional? What are their superpowers? Do they have extraordinary vision, operate at high clock rates, and act as pied pipers? Do they show creativity, curiosity, and intelligence? Is there evidence of perseverance and grit in their backstories? What is their level of self-awareness, and do they have head-room as leaders? With multiple co-founders, is there strong chemistry and do their skills complement each other?

• One thing that has become clear to me over time is that successful founders are less about the resume, although what they’ve done can help inform their ability to identify market opportunities and provide insights into their personal characteristics. I like Chris Sacca’s quote from this article: “The most successful founders are listeners, thinkers, and tinkerers. They are iterative, reflective, and rigorous. They passionately believe they are right but enjoy when their assertions or conclusions are shredded. The very best feel that yes is boring, and they thrive when wrestling with no.”
• A good long read on this topic is Ben Horowitz’s book, The Hard Things about Hard Things.

Market

Is the market massive, or does it have the opportunity to become massive? Is there simple, realistic math that shows a multi-billion-dollar market in terms of annual revenue and hundreds of millions of revenue annually for a company with reasonable market share assumptions? Sanity check “founder math” with diligence and primary research.

• In thinking about markets, it is important to understand that there are two kinds of market opportunities: very large existing markets that are ripe for disruption, and non-existent markets with the potential to become huge.
• Peter Thiel covered this well in Zero to One.

Why Now?

What tailwinds can the company ride that makes this opportunity compelling? Tailwinds can be technical, market-related, or cultural. (I covered this in more depth in the previous post on market trends.)

What is unique about their approach?

Could be a product insight, a business model insight, network effects, or something else. Regardless, investors and founders should always be able to point to some sustainable source of differentiation.

Are the milestones sufficient and aggressive?

It’s easy as an investor to think analytically about what can go wrong, but as discussed in the power-law post, this is less interesting than thinking deeply and critically about what can go right. Said another way, if you look back in 10 years and say you nailed something, what was it? Alternatively, as Fred Wilson from Union Square says in this post, how do you “find a way to say ‘yes’”?

What are the key risks?

Risk identification is less about trying to be comprehensive and more about deeply considering the most critical risks and what could be done to mitigate these factors over time. For a simple example, with a first-time founder, a key risk could be that they’ve never run a company before. One recommendation could be to have them to hire an executive coach from the outset to set them up for success.

What is the path to 50x?

This is not as obvious as you would think, as it requires thinking about two things: first, what is the potential for the business (market and the model analysis above) and it’s worth down the road, and second, how much capital and dilution will it take to get there.

• If you’re early-stage investing in a robust public market environment, be careful. When companies trade at 20x revenues, as some do at the time of writing, it’s easy to justify that many opportunities could be worth a billion dollars and then it’s open season on the investing front, just when it could be a time for caution. Conversely, in depressed public market environments and companies are trading at 3x revenue, it’s hard to justify any investment, even when that could be the best time to invest.
• Dilution is worthy of a separate post. Most seed-stage investors underestimate entirely how much dilution there will be down the road for their rocketships as the companies need incremental capital to fuel the growth and incremental options to hire and create incentives for their team. But a simple rule of thumb as a seed-investor is to assume at least 60% dilution unless there’s a distinct point of view on the potential capital efficiency of the company.
• The path to 50x is also a valuation discussion, but ultimately valuation is determined by the market, and it’s important to be wary of opportunities that seem to be a good deal as there’s little concept of “value investing” at the early stages of the market. In other words, the market may have decided the best companies graduating from YC are worth $10M, so it’s likely a better strategy to decide which of the best companies you want to invest behind rather than pick the one valued at $5M because it seems like a good deal.
• Related, be wary of the safe 5x. For early-stage companies that are burning capital, there is no such thing as safe, and you need to see the outlier returns as potential to compensate for this risk.

Take this framework as one perspective. For other interesting viewpoints, I thought Roelof Botha’s investment memo for the seed at YouTube was exceptionally well reasoned. Most importantly, develop your own framework, be explicit about it, and hold yourself to a high standard in staying true to that thought process.

At this point, you’ve decided to invest! Convincing founders to take your investment (Win), working with your portfolio to increase the likelihood of success (Support), and ultimately generating liquidity from your investment (Harvest) is covered in this post here.