Common sense in Venture Capital

Many of the common sense lessons that we learn early in life do not seem to apply to Venture Capital — Why?

Venture Capital is highly counter intuitive. Basic financial concepts such as prudence, cost discipline, company valuation, portfolio construction and investor behaviour are often widely different in VC than in the rest of the financial world.

Often times I have the feeling that we, Venture Capitalists, operate under a different set of rules, a parallel universe without economic gravity. From the outside, we seem overoptimistic, visionary and sometimes erratic. Our results seem to be driven by luck and passion in equal amounts and our investment theses are closer to poetry than to a rational investment strategy — but is that true?

The answer is not exactly. While the fundamental rules of finance still apply in Venture Capital, there is an additional set of rules that often dominate the dynamics of our industry hiding the influence of the first set. Venture capitalists learn to play by these rules and behave most of the time rationally based on them while looking foolish or even crazy to the outside world.

Here are some of these additional rules specific to VC:

Perception drives business results

As a startup, if the world thinks you are killin’ it you can raise more capital faster than your competitors leading to more and faster investment in talent and growth and, as a result, guess what? 👉 you are killin’ it

So, for the outside world you are always successful (even if it is not always true 🤘)

The same applies to VC Funds. If the world thinks the VC firm has a great brand, dealflow improves and the VC can become a great brand.

Reducing costs is not always the right solution

In a world driven by perception, lowering costs might can generate the wrong signaling and break the virtuous cycle of growth ➡️ funding ➡️ talent ➡️ (more) growth . That is why VCs might be reluctant to reduce costs and sometimes prefer to extend the company‘s runway with bridge loans. On the other hand, the fundamental rule of having to have a viable business model down the line still holds, so one has to be careful not to overfund companies or allow them to operate inefficiently for an extended period of time. Also, external factors (like covid-19) might make it impossible to survive without cost-cutting.

Paying lower valuations does not lead to better returns 👀⁉️️

This one is probably the crown of counterintuitiveness 👑. It seems crazy that paying higher valuations can lead to better returns but there are good reasons for it:

• Companies are cheap or expensive depending solely on future growth. Some companies grow so fast for so long that justify almost any valuation, the key is to not pass on them because of price. Sequoia invested $100m in zoom at ~$1B valuation and made ~40x in 3,5 years 🚀 In my view:

When your brain says the valuation is too high it is your heart speaking that the company is not good enough

• Valuation multiples are persistent. If a VC overpays at the Seed, it is very likely that this will be transferred to the Series A so that the uplift will be similar as if it had not overpayed. Also, since perception matters and the company is the sole issuer of shares, price discovery is severely influenced by the founders and the existing investors.
• A reputation of being price sensitive as a VC is a structural disadvantage: Dealflow is the most important element in VC and Angels and Seed Funds (besides your own reputation) are its gatekeepers. If they feel that a VC is not going to give them the best deal they will not call him/her first - it’s that simple. 📵

Larger portfolios generate higher alpha — “deworsification” is not a problem

There has been a number of studies showing that the distribution of returns in VC follow a power law. That means that the probability of finding outliers that generate outsized returns is much higher than in a Normal distribution. Hence, increasing the size of the portfolio has a much larger impact in a world dominated by the power law than in a “Normal” world.

As shown in this study by angelList, increasing the portfolio size has a “net positive” effect, i.e. the larger the portfolio, the larger the expected value of the Fund returns 💣. While in the theory this portfolio increase has no limit, in the real world studies have shown that the positive effect of increasing portfolio size reaches at least beyond 100 investments per fund.

The contrarian approach has a hard time

Venture Capital works like a chain with multiple Funds investing subsequently into one company over time. Each of the Funds will typically lead one round of funding and will follow its pro-rata after that. If the company cannot convince a new investor to lead the next round the chain will stop and growth will slow down. Herd behaviour, although sometimes very dangerous, is somewhat necessary in VC in order sustain the chain of funding and allow the company to grow. Moreover, since price arbitrage is not a large contributor to VC returns the benefits of taking a contrarian approach are limited.

Can you think of more specific rules to VC that look counter intuitive to the outside world? Feel free to comment them here or DM me at my twitter account @guillemsague

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About myself: I’m VC @ Nauta Capital focusing on Enterprise Software