What’s the Best Way to Learn About Venture Capital? (Part II)
Part I started with a simple question: what’s the best way to learn about venture capital?
After several wrong directions, 3 clues led down the unexpected path of martial arts. If you haven’t read Part I, it’s worth starting there for some context.
Having covered the White Belt lessons, it’s time for Green Belt.
Moving up to green belt in karate means an emphasis on improving technique.
The beauty of technique is that it’s a great equalizer. Even a child can deliver a deadly move with the proper technique and enough speed to overcome brute force.
In venture investing, technique over brute force is very relevant during due diligence. It’s tempting for large investors, especially those with experience in private equity or hedge funds, to apply brute force to due diligence in venture investing. After all, more information seems to be superior. Unfortunately, this can be a giant waste of resources with no extra benefits.
Of course there are certain minimum standards that need to be met in terms of legal and other issues. Beyond that, however, a typical early stage company would be in danger of being completely overwhelmed under the crush of a brute force due diligence approach.
It’s better to have a disciplined and repeatable process that is actually customized specifically for venture investing.
At Fresco Capital, we start with the team first and go through a structured process of qualitative factors. When people hear “team first” they typically assume gut feel, but actually we are looking for specific factors. For example, founder/market fit, or how the skills of the founding team match with the market needs. If you have a highly experienced enterprise fintech team in Asia creating an anonymous social network for US college students, that would be poor founder market fit — this seems obvious, and yet we’ve been amazed at how many teams have this gap.
Beyond the team, we of course also look at the product and market potential and it’s here that we end up with the largest drop-off rate during the process. When a great team meets a terrible market opportunity, the market opportunity wins. It’s possible that the team does a massive pivot to a new successful market but we’re not smart enough to invest on that basis in a repeatable way.
Finally, we of course have to review the actual deal terms and structure. Importantly, we don’t even look at deal terms and structure unless we’ve gotten past the team and market, which obviously saves a lot of time. There’s no tweaking of terms that can get us excited enough to invest in a poor market opportunity.
Some people make karate very complicated but the true masters give a consistent message that the highest level of karate performance is simple. It’s difficult and challenging to reach such this highest level, even though it looks simple.
In venture investing, it’s actually easy to make complicated term sheets. Many times, this involves starting a term sheet from scratch and then re-inventing existing terms and probably adding in a few new inventions.
Super-ratchet-participating-preferred-triple-dip-preference. There, I just made up a crazy new term in 7 seconds. That’s the easy part. The hard part is figuring out the true legal and economic implications over the next 8 years through multiple rounds of fundraising and an M&A exit.
This is not simply a problem for first time investors. Many experienced investors like to add in extra bells and whistles which seem creative at the time and then lead to unexpected problems in the future. Multiple liquidation preferences seem like a great idea until they are subordinated to someone else’s multiple liquidation preferences.
The key to term sheets is to have a clear understanding of your top priorities and what’s important to you. If your goal is to have a board seat, then perhaps you may need to be more flexible on valuation. If you want to be aggressive on valuation, expect to give up some control elements. Yes, in theory it’s possible to be extremely aggressive about all of your requests and push to get everything in your favour but then that means you’re probably investing in a lemon, not a great business. Better to give a fair offer which still reflects your priorities.
I’ve come across investors who take a 70%+ ownership stake in a startup during the angel round. I wouldn’t call these angel investors — they’re more like vulture acquirers.
In traditional Okinawan karate, farming tools were transformed into weapons. Even compared to these tools, however, the mirror is the most powerful tool in the dojo.
Why? Because it gives you the closest thing to totally unbiased feedback. There are countless times where I thought that I was moving my arm in a certain way, only to look and the mirror and find that, to my surprise, my arm was in the wrong position. That direct feedback accelerates learning and growth like no other tool.
It’s easy for venture investors to get complacent because there are so many startups chasing investors. Some investors do abuse this situation and treat founders as lower class citizens. I’ve seen founders giving diligence feedback to other founders about these toxic investors — there’s a lot of swearing involved.
Other investors are not intentionally mean, they simply enjoy living the good life and may not feel the same level of urgency as startups to get things done.
Of course, this doesn’t mean that all founders are perfect. There are also some founders who try to take advantage of investors.
In karate we can find a mirror to get very clear feedback. In venture investing, the process ain’t so simple.
Of course venture investors should proactively ask for feedback from startup founders and other ecosystem partners. Some people are very frank with feedback.
But not everyone. In fact, most people will typically shy away from direct criticism. Especially if you are a large investor in their company with a seat on their board of directors.
So in addition to explicit feedback, you should keep an eye out for implicit feedback. For example, in highly competitive rounds where there are more investors than allocation, are you able to get more than your pro-rata share of the round?
We feel fortunate to consistently be in this situation where even in rounds with excess competition, we have been able to secure allocation in excess of pro-rata. There are many different variations on this theme but they are all focused on measuring actions because that is closer to the feedback given by a mirror.
Brown belt training moves the focus to strength and power.
Some people believe that building a huge upper body is the key to strength. Traditional martial arts takes the opposite view and emphasizes strength at the bottom. A popular saying in our dojo is “when in doubt, get lower.”
After raising money, especially a large venture round, it’s tempting for a startup to add extremely experienced management talent and board members. For example, making a Rolex VP of Sales hire.
Unfortunately, many times these expensive hires don’t have a positive impact on business results and sometimes can even result in the business moving backwards. Yes, it’s important to have people who have succeeded in the past but the reality is that new startups are usually solving at least some new problems. The old playbook can provide guidance but it’s not a detailed instruction manual.
A bottom up talent management strategy requires patience. It means hiring more junior people who are expected to improve over time. Then investing the energy and resources to help them grow.
To be truly successful with a bottom up talent strategy, you need to build a strong foundation of support. There have to be quick feedback loops to help new hires understand expectations. The good news is that, over time, a peer-to-peer talent management culture will evolve naturally, which will help to scale the process. It’s more work in the beginning but it’s ultimately more powerful than a top heavy approach. You can even make a bottom up approach work with interns, like we’ve been doing.
The flying kick was one of the signature moves of Master Ansei Ueshiro. If someone is going to practice their flying kick on you, the level of trust needs to be extremely high. Traditional karate training emphasizes communication and trust in partner training.
After investing in a company, there are two kinds of mistakes. The first kind is to be too passive and say something like “call me when the exit happens.” The reality is that every company can benefit from some help from its venture investors.
Conversely, if you end up trying to micromanage the company, then you’ve ended up with employees instead of entrepreneurs. In that case, it would have been better to start the company yourself.
The middle ground between these two extremes is to be proactive. It’s much better to prevent problems than to fix them. This requires honesty to ask difficult questions in order to identify the challenges before they become problems.
This is one of the hardest nuances of venture investing because the only way to feel comfortable with this approach is to build up trust. Rather than saying “your go to market strategy is wrong”, it’s worth opening up the discussion with a question such as “what do you think are the challenges off this go to market strategy?”
If you’ve built up a high level of trust, the founders will feel comfortable to open up what they feel are the challenges and you can share your views.
Breaking bricks and other objects is one of the fun parts of karate training. One of the most important things to remember about breaking is the important of focusing all power on the smallest surface area. This leads to maximum impact.
Many investors from the private equity and hedge fund worlds try to copy the systems and structure of larger companies into venture backed startups. The problem with this is approach is that most of the systems and structure won’t ever be needed. In fact, they actually subtract value because they consume precious management time.
That 9 person “Committee for Cross-functional Interdepartmental Collaboration” which may possibly be needed at a large company is absolutely not going to add value at an early stage startup. The 7,215 row Excel model for Monte Carlo Simulation of how geopolitical scenarios can impact revenues? Also not needed.
Venture backed companies benefit from focus. It helps if the company has a clear mission and values so that decisions can be made without detailed rules — instead, they can be linked back to these high level ideas.
Even on the tactical level, it’s helpful to identify a key set of metrics, ideally just one at a time. This metric can change monthly, weekly, or even hourly. The main thing is that everyone is working towards the same goal to remove the short-term constraint. Once the constraint is removed, then energy can move on to the next constraint. This principle can dramatically improve execution at startups.
The core metrics approach can apply to many things. A core metric for writing could be “500 words per session”.
In Part III, we’ll conclude the series by moving on to Black Belt lessons.
