4 ways to break VC network effects
It’s well known how network effects play a key role in building and scaling great companies. They establish moats by creating barriers to exit for existing customers and barriers to entry for potential competition, and are most clearly seen in defining winner-takes-all markets.
But network effects are not uniquely significant to software companies or marketplaces, they are also a success factor for Venture Capital funds and can be seen to play a key role in defining who wins and who loses. While VC is not quite winner-takes-all, the extremely skewed nature of the market does mean that a few winners take most, and if you’re not in the top quartile you’re not playing the same game. So, given that only the top tier of VCs perform well and deliver strong returns, and given that the performance of those portfolios are driven predominantly by the outsized returns of a handful of companies that are ‘big winners’, it is clear that access to the very best deals is necessary for any VC that aims to be best in class.
Access alone, though, is not enough, rather it is a continuous process of finding, picking, and winning those very best investment opportunities, and thereafter adding value to them to contribute towards their success. And every step of that process is aided by the power of networks, from the relationships and referrals that help with finding opportunities, to the access to insights that help with picking, through to the networks of potential customers, talent, and other investors that can be opened up and help to win the deal and add value to its growth journey thereafter.
So, when established funds have built success over time and long since started to nurture and leverage the network and reputational effects that suggest the winners keep on winning, how can a new investor enter the market and start to outcompete?
1. Find the right market positioning
For new funds, this likely means identifying either:
(a) An investment stage that is not the focus of incumbents, or where they have weaker reputational and network effects.
(b) A vertical within which the new VC believes they have a stronger density of networks than an incumbent generalist fund.
At J12, we have focused on the former.
In the Swedish investment space, as well as across other maturing ecosystems, established funds have been growing in size and moving away from the real early-stage space — as their increased fund sizes lead to the need to write ever-larger cheques. While at the same time, the number of individuals and volume of capital at the angel stage has swelled in recent years as startup investments have become more attractive and accessible. This has led to a noticeable seed-stage gap, otherwise known as ‘the valley of death’, and presented an opportunity for new funds to enter the market — a few have entered in the last couple of years, but the go-to player is as yet unidentified…
2. Operate a structure & strategy that establishes network effects from day 1
If you don’t have 100+ portfolio companies that have spread themselves around the world, and decades of nurtured trusted relationships with collaborators, potential customers, and investors at later and earlier stages, then you necessarily have weaker networks than the established institutions already on the market. And therefore it would be a poor strategy to implement a standard approach and wait for time to do the work of catching up. Thus, your structure and strategy have to give you an immediate competitive advantage.
For us at J12, it is our uniqueness as a fund & angel group combination that enables us to have greater reach in our resources and relationships. We have been working with the angel group DHS Venture Partners for almost five years now, refining the art of bringing 25 successful individuals together to function cohesively as one unit. Think of the way large private equity firms work with industrial advisors, and that’s what we have applied to the very earliest stages of venture, integrating this group into our investment process so as to source and analyse opportunities together, co-invest alongside them, and work together with them in supporting the growth of the portfolio.
3. Gather a Limited Partner base that adds value and network too
Just as startups raising capital talk about the pursuit of ‘smart’ money over ‘just’ money, so it is the same for fund managers. Limited Partners, those that invest in a VC fund, can range from large pension funds to successful entrepreneurs, and all generally have some value to bring to the table, whether it is vast knowledge of fund administration, as in the former, or great experience in building winning companies, as in the latter.
For us, building an LP base that consists of a lot of entrepreneurs, active angel investors, and later-stage funds (via the Partners as individuals or the funds themselves) has created the potential to further strengthen networks and relationships to be successful at every step of the core funnel of VC activity, from sourcing → picking → winning → adding value.
4. Make good investments
While there are a great many factors at play, it’s fair to say that success breeds success. Investing early in startups that grow into impressive companies creates networks through those journeys, provides knowledge and experience to partners, and builds trust and credibility. Establishing a strong reputation creates magnetism, and thus great founders are attracted to working with VCs that have backed great founders before them.
There is no substitute for this, so all you can do is start building a track record of exciting companies that are growing and led by founders that will vouch for you. We have been fortunate to be amongst the first investors in companies such as Karma, Insurello, and Formulate, with a diverse portfolio and strategy that places us in the top tier.
Takeaways
The skewed returns of venture capital mean that you have to be playing at the top table in order to succeed. Given the impact of networks and reputation on those chances of success, and the advantages that incumbent funds hold as a result of having established those over many years, new funds need to be well-timed and well-positioned, with new structures and strategies. And they have to get off to a flying start.
If you want to know more about how we at J12 are addressing ‘the valley of death’ with outsized resources and networks, and an exceptional portfolio of companies backed from very early on, don’t hesitate to reach out.
And if you have any comments on the article, or views on the topic, I’d love to discuss further!
