Are you an a**hole?
Some VCs are perceived as a**holes.
Not you obviously. But maybe your partners are?
You can use our survey template to start measuring your firm’s NPS today by sending it out at the end of each month to all the founders who pitched you. Typeform allows you to copy the template to customize it to your needs, just let me know if you’d like me to share this with you.
If it turns out that your NPS is crap, what can you do about it?
Angela Kingyens @ VersionOne released the results of their post-pitch survey, and found that the three actions that most impact an entrepreneur’s likelihood to recommend them are:
- Decreasing response time and spending time with the entrepreneur
- Giving the entrepreneurs helpful feedback (even if you know less about the topic than they do)
- Clearly communicating their investment thesis was the single factor that most affected NPS
Communication, constructive feedback and responsiveness? I agree, sounds too hard
Noam Wasserman @ HBS studied equity splits adopted by 3,700 founders and found that willingness to have hard conversations around items which are critical for founder relationship success is a long-term indicator of enterprise value.
Ok, obviously. But as we all know, founders are really good at covering up issues among themselves during the fundraising process. So how can you dig deeper into founder dynamics without intruding?
Rishi Garg @ Mayfield had some smart suggestions when interviewed on the Twenty Minute VC (paraphrased by me):
There are a few key questions you can ask that are leading questions which help in understanding how much time did they spend on making hard decisions.
So some simple questions:
- How did you guys divide the pie and how long did it take to divide the pie?
- What’s been the biggest question or issue that’s come between you?
- Have you been able to have authentic conversations about your strengths and weaknesses?
What should you be looking for?
Just knowing that the founders discussed hard issues such as equity splits transparently among themselves (even if they ended up just dividing it 50/50) is a good sign.
Market adoption in slow moving industries
When evaluating startups targeting technologically conservative end users (think shipping brokers, small business owners, etc), being able to assess likely speed of adoption is critical.
But market timing is notoriously tricky. How can you better predict the diffusion of innovations in slow moving markets?
Before Crossing the Chasm
Ok, so nobody can consistently predict market timing. But what about rate of adoption?
The book “Diffusion of Innovations” (which is the more academic predecessor to “Crossing the Chasm”) does a good job verbalizing the key characteristics of innovations that predict their different rates of adoption. In particular, it advises us to examine how an innovation stacks up against the following five qualities:
1) Relative advantage
The degree to which new items are perceived as better than an existing, established idea (not only in objective economic terms, but also in feelings like social prestige and satisfaction).
How much change in behavior does the innovation represent and is it interoperable with previous practices? Includes fit with sociocultural values, previously introduced ideas and problem/solution fit.
The degree to which an innovation is perceived as difficult to understand and use.
Can the target market try your item out without much consequence if they decide to back out?
The degree to which the results of an innovation are visible to others (ie easy to observe and communicate).
These five elements predict about half of the adoption curve. To learn more about the other half, check out a great summary of the book here.
We never lose
I met an investor recently who, as part of his introduction, proudly mentioned his firm has invested in 15 companies in the past years, none of which have gone out of business to date.
How embarrassing for him.
Cockroaches and Zombies
Here’s the short version of an interesting study from Industry Ventures on VC loss ratios:
- Of 500 investments made by 20 early-stage funds in their portfolio, 45% of failed to return 100% of capital, while another 34% returned less than half. Mama Mia!
- Funds with loss rates near the lower or upper bands of their peer group tend to underperform because they take too little or too much risk.
- So a loss ratio of 35%-70% may signal a healthy balance between risk and reward.
So if you are over optimizing for investing in cockroach and zombie startups that never die, you can pat yourself in the back, because nobody else will.
Investment Memos are Broken
Well, at least mine is.
I published my startup assessment template a long time ago and I have to admit, as a decision making tool for live deals, it’s broken. Deals are usually debated via email, chat and verbally in partnership meetings, and memos can’t keep up.
So we’ve revamped our format.
At LionBird we’ve set up a homemade system for investment scoring that is light enough to be done prior to decision making, takes inputs from the whole team and covers the most salient points of investment.
This version is geared towards the fundamentals of early-stage, pre-traction investing with a focus on: the team, market, strategy, and “intangibles”. We find this helps us to contextualize opportunity cost and to focus on the fundamentals of an opportunity, rather than who else is investing or what kind of valuation we’re getting.
Making investment scoring useful but practical is always a challenge, and we’ll continue to tweak this going forward.
Upping your Reference Game
What is the goal of founder reference checks?
Beyond validating what a founder has or has not done and checking if they are psychos, IMO reference checks should focus on:
- What are the founder’s weaknesses?
- Did they really stand out in the past?
- Is this someone I can work well with?
Here is how to hone in on these three points in an impactful way.
Three Smart Reference Questions
#1: Uncovering a Founder’s weakness
From Scott Cook:
— Cook asks, “Among all of the people you’ve seen in this position, on a zero to ten scale, where would this person rank?” They go, “Seven.” Cook says, “Why isn’t this person a nine or a ten?” And then you’ll finally start learning about what this person really thinks.
From Trifecta Capital:
— What type of team members complement Jane’s weaknesses? (sometimes reference checks are hesitant to share any weaknesses, this illicits a response)
#2: How much does this person really stand out?
Two direct but good questions:
— What makes you believe this person is extraordinary?
— And what’s the most impressive or impactful thing that Jane did for the company?
#3: What is it like to work with this founder?
Questions from Tom Tunguz:
— How is the referenced persuaded or convinced? What kinds of motivation does he/she respond best to?
— Given it’s likely we’ll work with Sue, what advice would you have for us on how to best work with her?
At LionBird, we’ve recently been approached by a few startups that have raised too many round extensions and need a reset. When they get to us, we see a compelling team (there’s a reason others invested so much), a logical story of “why now” which builds on current assets and a bargain valuation being offered.
But if you don’t have a well thought out rationale for what’s not working, you can lose a lot of money in these deals.
Learning from the “turnaround pros”
Whether you’re thinking about investing in a turnaround case from within your own portfolio or someone else’s, it’s useful to examine the strategy of Tech RX, termed “the Silicon Valley Fixer uppers”.
What strikes me is that they structure their involvement similar to private equity firms in terms of exit scenarios, governance and ownership targets:
— Exit case: They first check whether the top talent has stuck around and whether they have the right attitude. They then examine financials in detail. Lastly, they assess the landscape of potential buyers. If there are no logical buyers in sight, Tech-Rx won’t step in.
— Control: from VentureBeat- “The firm’s №1 rule is that the current team must give control to Tech-RX and its partners — whatever Hogan says, do it. For the duration of the “turnaround,” the firm retains executive management and financial control.”
— Financial: Tech-Rx invests between $500,000 and $5 million into companies, taking 50 percent of the common stock, offering 20 percent to any new management it brings in, and leaving 30 percent for existing shareholders and founders.
So the next time you are tempted to restructure a startup, it’s worth considering whether you are well structured yourself to do so. Most VCs aren’t.
The famous book I hadn’t heard of
Ever heard of Carlota Perez’s book “Technological Revolutions and Financial Capital”? Well, Fred Wilson attributes her work as foundational to his investment thesis, and Marc Andreeson says she wrote the single best book to understanding how the software industry works. So I set out to understand why this book gets recommended so often and what practical lessons I can take away as a VC.
Having recently finished reading it…I’d be surprised if others have actually read every page in the book. It’s very academic.
Luckily for you, I’ll share my key takeaways below.
A question that’s been on my mind for a while now is whether this vintage’s returns will be harmed by larger funds raised and rising valuations.
Well, according to Carlota Perez’s book which studied past cycles, new technology is adopted on an S-curve. The last phase of the S is where technology reaches widespread use and the real money gets made in aiding that diffusion. This was true of the industrial revolution, the age of steam and railways, the age of oil, cars and mass production, and, if it’s true of the current ICT revolution than the best investment opportunities are still ahead of us.
Once you have this in mind, the reasoning behind the predictions and behavior of many other leading VCs becomes much clearer. For example, read recent investment theses put out by Battery (start at slide 12), 8VC, USV and the smart folks at LionBird :) and you’ll see they all have the same core belief: that the best opportunities lie in broadening access to digital smarts.
Let’s hope we’re right.
- Given this is just a bite, I won’t attempt to summarize the book here and am leaving out a ton of nuance. For that, check out Jerry Neuman’s fantastic post or this very thorough summary by Allen Cheng
The Numbers Game
While it feels odd to admit, startup fundraising (even for those that end up being top performers) is oftentimes a numbers game, where the right warm intros can be of enormous help to founders. So in cases when founders need to pitch 50+ investors to find the right match, it’s no surprise that they often turn to their current investors for relevant intros.
Besides the usual networking, what can we do to meaningfully impact the amount of qualified warm intros we provide to our founders?
Like most VCs, our best referrals to startups come from our existing portfolio founders, who happen to be “pay it forward” type people in general. So we decided to tap into this to amplify our own ability to be a good source of referrals to more downstream VCs.
To see the email we sent to our top portfolio founders that helped us add another 50+ names to our downstream investor intro database, click below:
The email has been the start of a wonderful resource for activating our portfolio founders networks in the service of others.
The value of value add
A lot of VCs won’t invest in companies where they believe they won’t be able to add operational value. This strikes me as an ok filter when applied at a high level to portfolio construction, but can be silly as rationale to dismiss an individual deal.
If you are thinking of investing in an opportunity that looks promising but that you can’t add much value to beyond being a good financial partner, here are three filters that may help you decide whether to do the deal:
- Can I do effective due diligence on the opportunity?
- Does this deal fit my portfolio construction strategy?
- Why do they want us in this deal (ie why am I so lucky)?
#3 is often the trickiest as we all want to believe we have a contrarian view or that the founder values us personally. More likely, you’re just a sucker :)
If you can’t DD an opportunity, have no good answer to “why me?” or feel you’ve done too many deals outside your core strategy, those are legitimate reasons not to do a deal. But if you won’t invest because you view yourself as a “hands-on” VC, you may be missing the bigger picture. After all, hands-on isn’t even what most founders are looking for.
Can you smell a rocket ship?
We all know that pro rata rights are valuable for doubling down on startup winners. But in practice, knowing when to follow-on in portfolio companies and how much to follow with is hard.
So what are some good ways to think about reserve allocations?
When to double down
Early stage VCs tend to overestimate their information advantage in follow-on rounds, leading to over exposure to pro rata opportunities. Mike Maples argues that we should instead treat follow-on investments like public market investors:
I say that follow-on investing is more like index investing than stock picking. When you pick, you have an infinite range of companies to choose from. But all follow-on investing involves you being allowed to invest from a fixed pool of companies.
So when you’re in that mode, you’re always asking: is my wisdom overtly greater than the wisdom of the crowds? Index investing kind of assumes this is not the case, unless you know something that you’re sure you know. The problem that I think most people have is that they believe they know more than the rest of the market because they are on the board or they know the founders better. But I give the market a lot of credit for being able to select what the good series A candidates are.
What I found is that, had I gone all-in every time a tier-1 investment firm followed, we would have lost money as much as not. But if we had done that and invested when we knew something explicitly, our follow-on investing skill would have gone up dramatically.
It follows that if you stick to these principles you may be left with less companies to double down on. Well, Floodgate reserved only 30% of its first fund for follow-ons, then 50% of its next one. Assuming your reserve allocation ratio doesn’t impact your reputation, perhaps it’s worth being more selective with follow-ons?
Can we effectively separate the work of VCs into discrete tasks and delegate to junior personnel?
Well, Noam Wasserman has been thinking about this since 2002, when he compared the pyramid organizational structure of other expertise driven firms (law, accounting, investment banking) to that of VC. In his dissertation, he followed a sample of 317 firms and measured how investment team structure is correlated with investment returns in VC.
What Noam proved -
- In Early Stage VC: firms with a higher ratio of senior investment partners to junior outperform those with the reverse
- In Later Stage VC: firms with a higher ratio of junior investment staff to senior outperform those with the reverse
Makes sense. When analyzing later stage companies, GPs can carve out more discrete objective tasks related to historical analysis without losing richness of primary source. Early stage is more subjective and details are lost when delegating responsibility.
One catch: in Noam’s study, the amount of structural leverage was measured as the ratio of junior investment personnel to senior investment personnel. What about the trend towards hiring “value add” or “platform” oriented personnel?
I’d assume if hiring “value add” staff enables your firm to provide founders with a meaningful advantage that they can’t get in the open market, this can make sense (note: reducing vendor procurement friction is not enough of an advantage). The danger of course is that if you have all these staff on hand I’d have to imagine there is a pressure to use them.
Need for Speed
Ideally as a VC you are engaging with founders you want to back in a value-add way well before they begin raising money. But sometimes it’s unavoidable: speed of decision making becomes a factor in winning a deal that you want.
On the other hand, as VCs managing other people’s capital, making quick investment decisions without doing proper due diligence is reckless. So how can you speed up internal decision making processes?
All Hands on Deck
If you are in position to be one of the top choices of an entrepreneur but don’t have long to build conviction, how can you speed up your internal processes?
Prepare for this scenario ahead of time. For example, from Frontline:
If a Partner thinks a great deal is about to be missed they are able to get all the other Partners to cancel anything non-compulsory in their calendar over the next week to get the due diligence, calls, meetings, investment committee etc. done within 5–7 days.
Whatever you want to call your version of this policy (at LionBird we call it a “code red” alert), it helps to be able to pull this card when needed. But I’d add to the above that you also need to use this process to build the founder’s conviction in you as a partner, otherwise you’re just running fast towards an empty finish line.
Misses > Losses
There is an old saying in VC:
“I don’t worry about the investments I passed on, I have enough to worry about with the companies I did invest in.”
That is exactly the wrong approach to VC where investment misses can cost you far more than losses.
So how can we productively revisit our bad decisions?
When enterprise startups lose a deal, they hold a sales post-mortem. In VC where the biggest misses cost far more than in any other industry, we should hold ourselves similarly accountable.
To do so, add one slide to your weekly meeting deck which includes the following points for discussion:
- Company name
- Value lost
- Why: what was our blind spot?
- Context: how much time did we spend on the deal? What other deals were in our pipeline at the time?
- Improvement: what can we improve in our investment process for next time?
Of course, if you are a reasonably sized fund all you need for good returns are a few good deals so you shouldn’t obsess over those you missed. But that doesn’t mean you shouldn’t learn from them.
On Fragmented Markets
Technology markets have in the past had winner takes all most (or at least most) dynamics. But many of the traditionally offline industries that startups are applying technology to today are fragmented for structural reasons.
So how can you tell if a startup is in a category that can support multiple winners?
For those with a high tolerance for academic dry reading, check out Michael Porter’s book “Competitive Strategy”.
There is a chapter on fragmented markets (= market share of the top 8 firms <50%) which itself is worth the price of the book. While a prerequisite to fragmentation is low overall barriers to entry, the book lists 10 additional causes of fragmented markets (mostly related to lack of economies of scale). Importantly, it only takes one of these for an industry to be fragmented.
Once you’ve identified the structural reasons for fragmentation in an industry, the book goes on to discuss ways to overcome it (also in the list). So the next time someone tells you “This is going to be a huge market with room for lots of players”, try to dig deeper on the why.
Since 2010 we’ve been hearing that the VC offering to startups (capital, advice and governance) would be unbundled.
The idea is that founders should be able to get advice from the people they want, to get money from the cheapest source and to leave the control provisions typical of VC-led rounds behind. However, almost a decade later, the business of investing in startups hasn’t fundamentally evolved.
Why might this be the case?
It all starts with the LPs- as Ravikant says:
“In the case of VC, money came with control — because the amounts being disbursed were large enough, it made sense that they needed to be actively managed. And because it was actively managed, you cared about how well it was managed, thus the advice.”
Until it’s proven with returns that LPs can successfully deploy capital at scale with unbundled GPs or their own direct to startup offerings, the bundle is likely to hold.
But I’m not convinced this is sub-optimal for early stage founders. If it were, the ones with the most fundraising options would operate differently, but this study found that they use their leverage to push back on terms while maintaining the advice and capital bundle:
“…repeat entrepreneurs receive more favorable terms for vesting, board structure, liquidation rights, and the tranching of capital, but did not receive greater equity ownership percentages.”
So why not raise at higher valuations from *dumb* money and then add advisors who earn equity?
From Elad Gil, it boils down to time scarcity:
“Why spend a lot of time searching for both capital & advice when you can save time by getting both through one investor?”
& skin in the game:
“…the one thing that an experienced VC partner can *uniquely* provide you is someone who has a strong incentive (because they own a lot of your company), and a very different perspective and experience base. That’s the old-fashioned “Investor as a Partner” model.”
Let’s see if this decade can change the equation that makes the bundle so strong.
On winning deals
Some deals are so clearly compelling that you have to compete with others to win them. How can you do so without resorting to selling on price/speed?
From Fred Destin’s experience leading Deliveroo’s Series B when they had 7 other term sheets on the table:
So you don’t win it on price actually, you win it by looking the founder in the eye and saying “I believe in your mission, I’m actually in love with your business, I’m on your side” and meaning it, you’re going to have to feel it. And then being a partner along the journey and making the person on the other side feel that that’s true.
Makes sense. Regardless of stage or geography, Founders rank personal relationship and chemistry as the single most important decision-making factor for choosing who to partner with. Everyone appreciates true believers, and even the less cool introverts among us can demonstrate this in our investment process.
Pat Grady @ Sequioa says working as a team has been their secret to longevity over time.
But when you go to raise a VC fund, LPs ask who sourced each deal and who sat on the board. Midas list and other media outlets further celebrate the individual over the team. And in terms of operations, having “deal leads” improves efficiency and accountability of deal management.
How can VC partnerships work as effective teams when the incentives are stacked against them?
Assuming one of your values is that you invest as a team, here are three ways to align incentives, culture and processes accordingly-
From Brad Feld @ Foundry Group:
“In about 90% of the companies we are investors in, two of us are actively involved. In about 50%, three of us are actively involved. But in 100% of the cases, we all know what is going on.”
From Pat Grady @ Sequioa (paraphrasing, 11:20 min in):
“In one fell swoop we changed all the names in the (CRM) database from individuals to the singular name “Team Sequioa”. And the point is that every prospect we’re talking with and every company with whom we’re in business today doesn’t belong to an individual, they are associated with Team Sequioa and it should always be a team effort in pursuing those things.”
From Doug Leone @ Sequioa:
“The investment partners don’t get fancy offices. Instead all the investors occupy an open space together with standing desks. And language is very important…we call everybody “partner.” If we hire a young investor and I’m one of the older people, I’ll introduce him or her as a “partner.”
It is possible to foster an environment where you perform better as a group than as a random collection of individuals. But it does require losing a few points of efficiency to gain a few points of culture.
Lets all agree to agree
There was a blog post by Bijan @ Spark Capital that presented consensus driven investing in VC as almost unconventional:
“I have heard some venture capitalists at other firms recall that their best investments…only happened because someone slammed the table and forced the decision…for what it’s worth the best investments at Spark have been times where our entire team was over the moon about the founder, product & mission.”
How common is group based vs independent decision making in VC?
It turns out that both in the early and late stages, group decision making is by far more common than independent.
Implementation comes in many flavors. For some entertaining reads on how others implement decision making, click below:
- Benchmark’s ballots system
- Bloomberg Beta’s “Anyone can say yes” policy
- FloodGate’s “pound the table” framework
- Founders Fund’s “snowball” system
- …& more
At LionBird, we’re conviction-based investors. This means we don’t do an investment without a passionate deal champion, and we also don’t invest if someone has especially strong conviction against a deal. We created a process involving company scoring and debate to support this healthy tension. To each their own! ¯\_(ツ)_/¯
How can you implement processes that take into account the time you’ve spent with companies post-investment to improve your reserves allocations?
While we operate in a world of imperfect information, here is a very practical article on how to build a process for reserve decision making. Like any forecasting exercise done in the face of uncertainty, the process is more valuable than the end results.
Alternatively, if you are in the camp that believes early stage VCs tend to overestimate their information advantage in follow-on rounds, go up to Bite #13 for a different framework from Mike Maples. His theory is that you should only follow-on in cases that a top tier firm is investing or when you know something explicitly that the market does not.
In reality, both methodologies can work together. Having your own view doesn’t mean you aren’t open to re-evaluating as you get feedback from downstream investors. At LionBird we assign Buy-Hold-Sell scores according to different valuation targets internally, but then when we get fundraising feedback we incorporate the quality of the follow-on investor into our deliberations.
Frequently adjusting targets/scores for companies according to the latest updates they receive can be tough at scale. But because we’re a small team with <20 active companies in the portfolio, we go over all the company updates each weekly meeting making coordination less of an issue.
The upcoming recession
Ray Dalio’s brief blog post “The World Has Gone Mad And The System Is Broken” is the most thoughtful take I’ve seen on why we are due for a market correction soon.
If his analysis is accurate, what can we as investors in startups do to prepare?
Bill Gurley on Recession
“Well, your business sucks. You can’t avoid cyclicality. I have a strategy for when I think yields are going to expand, and when they’re going to contract. I always have a game to play, because you’re going to always have boom-bust cycles.
In contrast, the VC business is low barriers to entry, high barriers to exit. So, as markets start to boom, the amount of capital that comes into the category is immense. But when the market breaks, the capital that doesn’t have a mechanism to go away quickly, because it’s already been committed to 10-year+ windows.”
So does this mean we should pack our bags and head home?
Not quite. Bill Gurley goes on to mention:
“The vast majority of the average returns over a multi-decade window are right at the end of the cycle. And so, if you get conservative and pull back and miss- like there were venture firms in 96, who said “this is way too overheated, we’re pulling back” And they missed 97, 98, 99. So, there’s this saying: “the best way to protect against the downside, is to enjoy every last bit of the upside”.”
The only tool we have to deal with a potential recession is time diversification via steady investment pacing. So even if you assume this cycle will end, unless you know exactly when then it doesn’t serve you to sit it out.
How many companies should you invest in?
The math says the best way to ensure you have a hit is to diversify your portfolio, but over simplified models have limited utility in real life. Usually when you scale the number of investments you make the quality of the portfolio goes down.
So what’s the best way to think about how many companies to invest in as a VC?
On constraints and edge in VC
First some basic math-
assuming you have a ~4% chance of 10x+ realized multiple on any investment, you should be investing in >15 companies for a 60% chance of an outlier, >20 companies for an 80% chance and ~24 for a 90% chance (but of course 10x won’t do the single handed job of returning the fund if you have an equal weighted portfolio of 20+ positions).
From that starting point — to determine how many companies you should actually invest in, consider what is your edge and what your constraints are.
For example, in terms of deal flow, if you’re seeing deals that are as good as the ones that you’re doing but you’re saying no to those, you can probably afford to grow your portfolio size.
On the other hand, paraphrased from Peter Thiel:
“Given a big power law distribution, you want to be fairly concentrated. There just aren’t that many businesses that you can have the requisite high degree of conviction about….Founders Fund tries to invest in 7 to 10 companies per fund.”
This was in 2010 and has since changed as they’ve grown AUM and number of partners, but the principle holds: it’s hard to find deals that can return 1.5x+ the value of the fund.
In terms of risk tolerance — the more concentrated your portfolio, the larger the impact of upside and downside scenarios. This is because higher ownership in a smaller number of companies means you have less chances to hit an outlier but if you do, it’s likely you’ll own more of it at the time of exit.
Another way to think about this:
if the almighty was a GP we would expect him/her to invest 100% of his fund in the earliest round of one company. LPs that invest in talented managers push for more concentrated portfolios for this reason, but you need confidence in their skill (or divine luck) to beat industry odds.
Depending on how hands-on you are in working with companies and how involved your selection process is, at some point you’ll hit constraints on time allocation. Tie that to fund size and there are further limits on the number of right sized deals (in terms of capital you can put to work per partner) you can make. This is what makes quality scaling of a VC so hard and is why bigger fund size usually translates to doing bigger deals at later stages.
In the end of the day, portfolio construction thinking should go beyond the typical sector/ stage/ geography conversation towards discussion of a GPs edge and constraints. In these tradeoffs is where we find the opportunities to improve!
When others are fearful…
We all understand logically that we should “…be greedy when others are fearful”.
But in practice human psychology is a b*tch!
How can you to look past the news cycle?
Correlation Ventures released a great study answering a simple question
Q: In retrospect, was the year immediately following the 2001 and 2008 shocks a relatively good or bad time to be investing in the U.S. venture market?
A: Yes! Realized multiples increased significantly immediately following 2001 & 2008 (look at the two bar charts on the right side).
In the 2nd chart below: look at the slope of the lines following ’01 & ‘08
What to make of this?
As Adam Fisher @ Bessemer wrote in his must-read blog post-
“Time diversification is a real thing in venture capital, including during periods like this…Three years from now when you look back, you will realize the biggest investment mistakes you made were in the 12 months preceding this crisis, not in the first 12 months following it.”
So give me a call if you want to discuss any of our companies :-)
What’s the right way to pass on an investment?
From a recent 20 min VC interview (edited for clarity)-
“It’s just such a complex equation that’s going on in your head that you can’t really articulate, so any time you’re going to try to do that you’re going to fail and it’s going to come off as inauthentic or vague.
And then even if you put a lot of thought into it the founders will often say “well you know you said it wasn’t a big market but it actually is a big market” or “you said this but it’s actually this”.
“Or most people lie and say it’s something else, and then the founder iterates on the feedback…leading the founder off track.
Frankly the #1 reason I pass is that I am just not impressed by the founders. How can you say that? How can you tell someone to their face “sorry the reason I didn’t want to invest in you was because of you”…The incentives just aren’t there for a VC to say “Look, you’re just not impressive enough.”
It’s a tricky dilemma, but there may be a solution.
Data based approach
As an industry we’re not great at passing on investments. How can we do better?
Ultimately, what I decided to do was look at the last 100 startups that I met who I ended up rejecting and documenting all the reasons I passed on them. With this, I am able to tell founders that while I can’t tell you in this specific case why I passed on your deal, I can at least provide you with an aggregate view on what I look for as an investor.
At the surface you’d assume it’s almost always an issue with the team, but having done this exercise myself it turns out that ~40% of my nos are to “VC fundable” teams (VC fundable = we would fund them if they were pursuing another idea).
Is this good enough?
To be clear, this is only meant to be sent to founders that you met once or twice. If you send this to someone that you’ve been engaging with for a long time, you’re probably just a jerk.
While I’m not totally sure whether this will be well received by founders, it seems worth the experiment if it allows you to be more transparent with founders while saving yourself time.
On repeat founders
We all know that entrepreneurs who have previously achieved successful exits have an advantage when it comes to their 2nd startup. But despite their higher success rates, there is an imperfectly competitive VC market in which prices do not get bid up to the point where excess returns from investing in serial entrepreneurs are eliminated.
If a company is started by an entrepreneur with a track record of success, then the company is no more likely to succeed if it is funded by a top-tier venture capital firm or one in the lower tier. Thus, prior success is a public signal of quality.
In other words, smart founders don’t need their investors to signal that their company is of high quality. They are their own signal. Instead, what is important to them when choosing a partner, besides achieving a fair (not crazy) valuation, is the investor’s reputation among their peers and the ability to trust you as a partner.
In a market where VC is moving from picking to getting picked, deal flow and name recognition are table stakes. More important is being able to achieve the concept of brand equity, meaning “a price premium over your competition that consumers are willing to pay”. In our case, you need to become the best money equity can buy.
Brand in VC
VCs like to say that they make their money through their best bets but they make their name through their worst bets. That isn’t true.
Everyone knows that a firm’s successful investments are their brand. That is why unlike in other asset classes, early success in VC is persistent.
So how should we think about how to allocate our time between struggling investments and the outliers in the portfolio?
For Doug Leone @ Sequoia, there is a simple answer to why he works closely with his struggling investments — it’s about being a badass.
Regarding the fund he was managing during the 2000 bubble (27 min into this podcast, paraphrased):
That was a formative time for the culture of Sequoia. We took the approach…that nobody was going to lose money at Sequoia Capital. And we went to work for 10 years to make sure those funds succeeded.
During those times there was no question what we were going to do. I don’t think we ever even had the conversation. We just had to. It had nothing to do with having to save our careers, our money, none of that. It had to do with being a badass and doing what nobody else would do. That’s what it has to do with. Do the right thing when it’s inconvenient to you.
It’s clear that they not only did a great job recovering investments (taking a fund that was at .3x and bringing it up to close to 2x) but in building an emotional narrative that connects with future partners and defines their values.
It definitely resonates with me. I’ve been amazed over the years at what my partners, former entrepreneurs and relentless optimists, have done to help the slower moving companies in the portfolio pull through. While the concept of “a bridge round to nowhere” has been popularized, I’ve seen very successful outcomes come out of multiple extension rounds and time spent wisely.
At the surface, these efforts are illogical at the individual level. But when taken in the aggregate, supporting your struggling companies should measurably impact your results and your reputation over time by allowing you to keep your dollar loss ratio far below your names loss ratio and by enabling you to build a reference list that is as powerful as good logos in helping you win future deals.
Founder fundraising timelines have become compressed. “If you measure average time to term sheet”, according to Josh Kopelman “You just see sort of what was a 90-day process shrink to an average of nine”.
How can you keep up with the pace of the market without compromising decision making?
I don’t like the word thesis.
It’s way too pretentious, reminding me of those hyper specific publications by academics that never get read (this gem from my UMich professor).
But there is value in having a prepared mind. It allows for faster conviction, rapport building and due diligence.
From Roelof Botha @ Sequoia-
“We go write a short investment memo internally not about a company but about a sector, and we analyze all the companies in that sector and we try to meet all of them, and we have a thought piece on it… In some sense you make a very fast decision to invest in a company but in some sense you have months to think about key trends and how they uniquely enable a company.”
Of course, if you’re an early stage VC it’s more about following great people than great companies, and you probably shouldn’t fall in love with your own ideas.
But being thesis driven doesn’t need to come at the exclusion of being team driven. Instead, you can think of it as value = market * people. You need both. You need a large market and you need a team of incredible people.
So how do you go about creating one of these fancy theses? A good place to start is with the CASH framework (described 10 min in here), which stands for:
- Constrain — your thesis is as much about what you don’t do as it is about articulating what you are excited and knowledgeable about
- Actionable — others should be able to know without detailed explanation what fits your thesis and what to send you
- Special (or unique) — people need to be able to remember you for it
- Helps — you to pick and support great companies
For those of you who are exclusively opportunity driven and still rolling your eyes, I’ll end with one more interesting quote from USV, 49 min into this podcast:
There’s a lot of ways to be a good investor and a lot of ways to build a strong VC firm. The ones I admire most are the ones that have a point of view. If we come to things with a prepared mind and a commitment to the thesis, it’s a good way for us.
On when to sell
We’ve all heard some iteration of JP Morgan’s famous quote “I made a fortune by getting out too soon”.
But is this the right way to think about when to take money off the table?
From Howard Marks’s recent memo-
“If you sell half, you can’t be all wrong”…this high- sounding verbiage can lead to premature selling, and cutting back a holding with great potential can be a life-altering mistake.
So what’s a better approach?
From the same memo (which is worth reading in full) -
As Charlie Munger says, “the first rule of compounding is to never interrupt it unnecessarily.” In other words, if you have a compounding machine with the potential to do so for decades, you basically shouldn’t think about selling it (unless, of course, your thesis becomes less probable).
Compounding at high rates over an investment career is very hard, but doing it by finding something that doubles, then moving on to another thing that doubles, and so on and so on is, in my opinion, nearly impossible…It’s much more feasible to have great insights about a small number of potentially huge winners, recognize how truly rare such insights and winners are, and not counteract them by selling prematurely.
Applied to VC
This sounds great, but as VCs we can’t hold onto an asset for decades, and as asset managers we have to intersect & optimize three distinct variables — value, speed & certainty.
Regarding certainty, beyond position concentration consider -
a) Firm implications — have you demonstrated success as a firm? b) Fund implications — have you generated an attractive return in the fund?
c) Partner implications — do your LPs care about timely distributions?
From Roger Ehrenberg’s blog post on the matter -
Now that IA is viewed as a serious firm, we can focus on optimizing value for LPs without concern for “proving ourselves”
ie after you have built a history of sending significant distributions to your LPs you may have more slack on the certainty portion of the equation and then can focus on your specific view on a stock’s value.
This can be the subject of its own book but one framework from the Howard Marks memo -
In today’s truly world-class companies with their vast but unquantifiable long-term potential…the correct approach is to (a) hope you have the direction and quantum approximately right, (b) buy and © hold on as long as the evidence suggests the thesis is right and the trend is upward — in other words, as long as there’s still juice in the orange.
I think we can all relate that imagining the size of some of these recent exits up front is tough (look at the outcomes analysis from on BVP’s Wix investment as an example).
While the above is not a very satisfying answer of when to sell I hope it will challenge some of the views popularized by yesterday’s value based investing dogma.
& with this I’ll leave you with one last thought from the memo that stuck out to me -
..one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk…When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell.
Note that, according to Charlie Munger, he’s made almost all his money from three or four big winners. What if he had scaled out early?
Winning the deal
Besides your brand, terms and speed, the most important element to winning a competitive deal is how you make a founder feel.
From Susa Ventures -
We call this “The Susa Experience”…this goes beyond the questions you ask to the interpersonal stuff…we’ve polled our founders and they say that that level of experience they had, the emotional thing, is a huge indicator of who they end up picking. And so we’ve spent a ton of time internally drafting what is the full touchpoint, what does every interaction look like.
How can you implement this insight into your process?
Your pre-investment product
Phin Barnes, formerly at First Round Capital, conceptualizes your investment process as a “pre-investment product”.
From this podcast (edited for clarity)-
Your pre-investment experience is your highest leverage point for distribution in the market (given how many founders you meet top of funnel)…& it’s a hard product to generate a high NPS because you are in a world where 99% of founders don’t get what they want (an investment). So you have this problem as a PM of your investor product that you have to create something that people will refer to their friends even when they don’t get what they want.
Given the amount of founders entering the digital health world for the first time, how do we stay engaged pre-investment in a value-add way? & how do you scale this activity beyond time intensive 1on1 meetings?
To answer this we recently interviewed 20+ stealth mode digital health founders. Our key takeaway: it’s about providing immediate value in every interaction but also about setting expectations up front for what you can expect from us at any given stage.
To support this, we’ve developed (work in progress) an internal library of highly tactical resources with the very specific “Israeli stealth mode digital health founder” persona in mind. I’d be happy to discuss the learnings with anyone that wants to reach out.
For those not thematically focused as we are, just running a transparent & clear process can help. Again from Susa -
Right after we meet or right when we are introduced to a company, we send them this really well designed one pager which is our portfolio, exactly our process that they’ll be going through with us end-to-end, the things we care about…that’s just a simple example but draw that out (across the journey).
Whatever it is you choose to focus on, differentiating on how you want the pre-investment product to be perceived is a critical piece of building your reputation as an investor.
On reserves governance
I’ve written about follow-on investing best practices a few times (Bites #13 and #24) but it’s a topic worth revisiting. Recently there was a great interview with Mike Maples (listen from 46:45 in) -
We believe that follow-on investing is about governance inside of a venture firm, and so Iris Choi is our partner who does 100% of follow-on investing decisions, independent of the first check partners. And so what Iris is willing to do is to say “for the checks I write, I’m willing to be accountable for the same aggregate returns as the fund as a whole”.
If she can’t, then our reserves should be even smaller, and if she can do better than the fund as a whole, our reserve ought to be bigger, but that is the valid way to think about reserves in my opinion ie what is the equilibrium where the multiple on reserves is the same as the multiple on first checks?
Naturally, after hearing this I did some stalking of this “follow-on specialist” to better understand her secret formula.
The follow-on specialist
To optimize follow-on investing, Floodgate has on staff an ex-Goldman Sachs partner (Iris Choi) who runs reserves as if they were a separate opportunity fund and is measured by follow-on investing performance.
From an interview with her on the genesis of this arrangement -
I pitched Floodgate on this idea that VCs love deploying capital…all the glory is “I wrote a first check into company x, y & z”…but now you are at a stage of maturity in the fund that we need to start harvesting exits.
Whether we like it or not, it’s in my DNA that every opportunity I see, even if it’s the first pitch, I’m thinking through: is there an exit path for this company? And if there is, what does that mean and how do we make sure they are correctly on that path?
To maintain neutrality Iris doesn’t lead any deals and only owns decision making for and is measured on the performance of the follow-on investment checkbook.
More on her day-to-day -
In practice, I’m very clear when I start working with a company: you need to have a fundraising roadmap the same way that you have a product roadmap.
I get to know the founders — if not in the pitch process than as soon as we write that first check in. Then when they are getting ready to fundraise I’m their first pitch, and I’m helping them set up their data room, build their financial model, prepping them for what a DD process is going to look like, making intros and hopefully I’m spending my time in the background talking to the series A and B investors to better understand what are the sectors they are looking at, what are the metrics that they are honed in on that would make them excited about an opportunity, facilitating those types of introductions.
I’d imagine that bundling her job as head of reserves with deep involvement in portfolio fundraising should lead to superior follow-on insights. And we can all apply those best practices to our jobs as VCs.
But I definitely would not copy/paste here — unless you have the right person, incentives, internal alignment and org structure in place, don’t try this at home.
On investing in nice people
A wise VC once said — “I like to invest in nice people…and to avoid assholes”.
But what about investing in CEOs that are not “nice”, or that are overly defensive, or that are not likely to be easily “coached”? Isn’t life too short to partner with founders that you may not always get along with?
If it’s a good business then no.
From an interview with Roelof Botha @ Sequoia:
When I first joined Sequoia Don Valentine took me aside and said — “There’s a 2x2 matrix of people we invest in. On the one axis we have unexceptional and exceptional, and on the other axis it’s easy to get along with and not easy to get along with. Your job today is to figure out in which quadrant we normally make money.”
Founders are different, they are people that don’t just accept the status quo, they challenge it. These are people that embrace challenges and want to take on the world and change it for the better. & so you want to lean into that characteristic.
This is supported by data. In what is likely the most detailed study of individual CEO characteristics at present, Steve Kaplan looked at 2,600 would-be execs who were assessed for 30 personality characteristics (when companies are looking for a new CEO, they offer hire-assessment companies like ghSMART to figure out what makes candidates tick, thereby producing some fine-grained data).
What he found, as outlined here -
Agreeableness — or how friendly and personal you are — increased the chance of a candidate getting hired as CEO. But what leads to company performance is execution.
Execution is about being efficient, persistent, proactive, aggressive, hiring high-performers, and firing under performers. In Kaplan’s model, execution is on the opposite side of agreeableness, and the being open to criticism and quality listening and people pleasing that comprise that trait.
“It’s not saying that you should hire a jerk, but that you hire someone who has a sense of urgency,” says Kaplan. “In many cases, they ruffle some feathers, but in a CEO, you probably want that.”
For the record — I prefer nice people to assholes (see the bottom *). And things like integrity are red lines, for obvious reasons.
There is of course also the “life is too short” argument to take into account here. Oren Zeev articulates it well -
I do it because I enjoy the process, I enjoy the experience, I enjoy the relationship with the founders, & life’s too short, so why would I want to put myself in a situation which I do not enjoy.
When I think about what’s best for our LPs — it’s not necessarily my enjoyment of my journey with founders. A VC’s job is to generate good outcomes, and to achieve that we have to learn to work with a wide range of people, some of whom may be less agreeable. We have to figure out how we can best support the great founders despite any flaws & quirks that may make them unique but also perhaps challenging to get along with.
— — — — — — — — -
*This Bite is more philosophical than personal. All of the CEOs I work with are incredible people who I greatly respect and have been lucky to partner with.
On shopping term sheets
In today’s founder friendly market, tactics like “exploding term sheets” are crude and out of touch, while “shopping term sheets” has become the norm.
As investors in this environment, what are the best practices for ensuring a smooth process from issuance of term sheet to signing?
Chris Dixon states it well -
Discuss things verbally and only accept a term sheet when you have agreed on all significant terms. At that point, assuming the term sheet agrees with what you said, you should sign it and return it within a day or two.
When there is mutual interest in getting a deal done, the process from verbal offer to signed term sheet should be a quick one. At LionBird, we treat this as a process alignment question — meaning after we agree on verbal terms, we literally kick off the process by telling founders -
“When we give a term sheet we have this process…”
and from there we align our calendars with those of the founders, reserving a 1 hour slot for each of next 3 days post-verbal agreement.
This is based on our internal benchmarks for how long it usually takes and allows us to pre-empt the classic “waiting for lawyers to turn this around” excuses by agreeing upon a schedule up front with minimum turn around times.
How this works out depends on the intention of each side. If there is mutual interest in doing a deal and there is clear communication of any special circumstances that’s fine. However, if the founder is interested in soliciting other offers, this process makes it easier to uncover that and you can then can decide how best to proceed.
Part of a founder’s job is getting a competitive process going for their financing to get the best deal with the highest quality investors. But this should be handled in the right way. Using data, process alignment and transparent communication to ensure you reach an end result faster should be positive for all parties involved, regardless of outcome.
It’s no secret that average dilution per round in VC has been going down for years. The days of “20% or the highway” are clearly gone but achieving meaningful levels of ownership relative to fund size at exit still matters.
In this environment, what’s the best way to balance flexibility and discipline in portfolio construction?
From this podcast comes an interesting framework (35 min in) -
To keep ourselves honest, we have a running spreadsheet where we’re tracking the percentage of the time that we’re achieving our ownership target and that creates a sense of comfort that when we’re creating exceptions it dings our internal metric.
To stay sane in this business you have to have rules and you have to have a framework. If every decision is a brand new blank slate decision you’ll go crazy. We do have rules, and we make some exceptions.
The goal is always to achieve disproportionately high ownership relative to fund size in great companies. But we know we won’t achieve our targets 100% of the time, and it’s ok to make exceptions if you are getting into the right companies.
However, if we only achieve our targets 40% or 50% of the time can we truly, in good faith, say we have a strategy?