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LionBird Bites Aggregation

All the past main body portions of LionBird Bites newsletter in one giant blog post. Sign up here for future editions.

Bite #1

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

Bite #2

Who Knew?

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.

Bite #3

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).

2) Compatibility
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.

3) Complexity
The degree to which an innovation is perceived as difficult to understand and use.

4) Trialability
Can the target market try your item out without much consequence if they decide to back out?

5) Observability
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.

Bite #5

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.

For context, even the great USV had a “names” loss ratio of about 40% in their first fund, which was reported to have an incredible TVPI of 14X.

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.

Bite #6

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.

Memo 2.0

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.

LionBird Scoring Template

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.

Bite #7

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?

Bite #8

Startup Turnarounds

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.

Bite #9

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.

Book Bite*

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.
— —

Bite #10

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?

Downstream Database

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:

Click Here

The email has been the start of a wonderful resource for activating our portfolio founders networks in the service of others.

Bite #12

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.

Bite #13

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?

Bite #14

Reverse Pyramids

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.

The Results

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.

Bite #16

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.

Bite #17

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?

Investment Post-Mortem

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.

Bite #18

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?

Michael Porter

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.

Click Here For List

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.

Bite #19

Unbundling VC

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.

Bite #20

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.

Bite #22

Deal Attribution

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-

Load Balancing
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.”

Attribution
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.”

Environment
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.

Bite #23

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.

N= ~900 VCs

Implementation comes in many flavors. For some entertaining reads on how others implement decision making, click below:

Click Here for Case Studies

This includes-

  • 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)_/¯

Bite #24

Follow-on Frameworks

While initial investment decision styles come in different flavors, follow-on assessments can be managed more systematically.

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.

Bite #25

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

The VC business sucks. At least according to Howard Marks, who told Bill Gurley:

“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.

Bite #27

How many companies should you invest in?

Historically, the best VCs have achieved superior returns by optimizing for larger hits, not lower loss ratios (see Bite #5).

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!

Bite #28

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 :-)

Bite #32

Saying no

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.

Bite #33

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.

Why? “Exited founders” (which refers to someone that started, ran and sold a tech company) tend to optimize for partner fit rather than purely on valuation or firm brand. From this paper-

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.

Bite #34

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.

Bites #35

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?

On thesis

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.

At LionBird, I can definitely say having a prepared mind for when we meet great digital health founders is the best way for us.

Bites #36

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?

Bites #37

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.

Bites #38

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.

Bites #39

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.

Bites #40

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.

Bites #41

On discipline

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?

Bites #42

On assessing founder teams

Do you believe you can look into founders eyes and get a sense of their soul? That’s wonderful, and you’re in good company.

For the rest of us: what might be done to objectively improve on our ability to assess founding teams in the future?

We as VCs generally know which attributes we want to see in founders, but the challenge is how to check these things out pre-investment. Most of us don’t know how to psychologically evaluate a team and instead just rub our tummies.

Similar to best practices in HR, it is technically possible to use psychometric surveys for evaluating founder talent. But in a competitive startup deal you likely won’t put founders through this sort of exercise.

What you need is a partner that authentically and credibly owns this part of the due diligence process. One that feels as comfortable asking personal questions of founders as we are asking about business models and TAM.

Some smart VCs have done this by hiring “startup psychologists”. Of course, founders don’t want to be examined and it’s all about how you position this.

From this podcast with F2’s Operating Partner/ in-house psychologist -
For me, since I’m in the psychological hat, it’s normal to start a conversation with the founders “Look, our kind of conversation is going to be different. We’re not going to talk about the business, we are going to talk about you. We’re going to talk about us. How we as a fund can serve you. Are we compatible for you?

What they’ve done here is split this role into pre-investment, which includes psychological due diligence on a 1-on-1 basis and in service of the investment committee, as well as post-investment founder dynamics and hiring support. This allows them to justify a full-time psychologist resource, similar to what Floodgate did with their “reserves specialist partner” role I covered in Bite #38.

For those interested in learning more, F2 began writing a guide on questions to ask teams to assess their intrinsic motivation, emotional regulation and mental flexibility capabilities as well as what to look for in the answers.

Bite #43

On financial plans

The one truism in venture is that the financial plan a founder puts in front of you likely isn’t going to come true. But that doesn’t mean you shouldn’t analyze it.

An interesting perspective from this 20min VC podcast -
There is actually a lot of insight in plans that people ignore — I find it lazy underwriting when they say “well the plan isn’t going to happen so why should I spend time on it?”
So what can we actually get out of reading early stage startups’ financial plans?

There was a multi-year forecasting tournament with 20,000 participants who made over a million predictions on potential geopolitical events that were more than a month but less than a year in the future. The leader of the team that did the best wrote a book called Superforecasting on lessons learned about the top 2% of forecasters in his group.

A key insight was the utility of breaking down forecasting problems into assumptions, exposing the knowable and unknowable parts. Putting this into action with startups, from the same podcast referenced above -
A lot of it is really spending time with the founder questioning what you have to believe in order for the plan to come true. For example you can ask about margin increases — do they understand where that margin improvement is going to come from? Do they already have plans in place? Are there resources being put against it? Is there a learning agenda?

Or is it just saying “we will figure out how to improve margins by two points every year for the next 4 years”. That’s a very different type of thinking than spending time with the founder really diving into the business itself and tearing it down into the atomic unit and figuring out where they are going to put their time and energy.

31% of early stage startups do not bother to forecast revenue (see Table 15 of this study) and that is unlikely to change. But even without a detailed excel, having a detailed conversation on key business drivers and founders learning agendas can unveil a lot about how teams think, what they already know and what they need to figure out.

Bites #44

On asking the right questions

What is the purpose of due diligence in pre-PMF startups?
Is it for uncovering material issues that may actually impact your decision to invest? Or is it for gathering information that makes you feel comfortable with your investment decision?

For most it’s the latter, & that’s fine. LPs deserve high quality due diligence that underscores their GPs’ value as responsible managers of their capital.

But for those of us that aspire to get more out of their investment selection process - how can we run a precise and useful investment due diligence process?

From Renana Ashkenazi @ Grove is very well done interview of Julie Yoo @ a16z -
We’re very precise on “what is the key question I’m going to focus on in the next 24 hours that I think has the most likelihood of changing my mind either way”. If we are doing this right then every card that we are turning over should make us trend up or down relative to where we were 24 hours before.

She uses this to stay in touch with her ”slope of conviction” during a process -
One thing I think very carefully about is the derivative function of my level of conviction over the course of time that we do diligence. Because in retrospect there is 100% correlation between the slope of that function and the deals that I do vs not.

And so I literally wake up every day and we have a numerical scale on which we measure this (our level of conviction). If that number is not trending upwards during the course of doing the work, that’s a signal to me that it’s likely that I’m not going to get there.

She is laser focused on uncovering issues that may actually impact her decision and avoids spending founders time on anything else -
We try to be transparent to the founders on what our key questions are and they can then focus on “just help us answer this one thing right now” vs sending them a list of 40 questions and having them run around collecting data.

I think about question asking a bit differently.
Great teams tend to enjoy on point conversations about their business, and great VCs know how to assess the quality of teams based on these conversations. Or as Don Valentine puts it -
“VC is all about figuring out which questions are the right questions to ask…We recognize by Socratic questioning opportunities that are better than others and why.”

So the issue is not asking too many questions, it’s asking the wrong questions with the wrong intent.

Great VCs also sell their partnership model in parallel to confirming the quality of the startup they are looking at. From Julie Yoo again -
“There’s nothing like a founder being able to pitch their vision and get a response that actually denotes an understanding of that vision. And so I think that’s a sales tool in addition to being a decision-making tool”
At the very least, by asking the right questions with the right intent, great VCs are able to leave founders with a positive experience (see Bite #37) regardless of end decision.

Bites #47

On Ego

VCs are not generally known for their humility, & this tends to be amplified at board meetings -

This weird thing happens when you take investors and put them in a board room with the other board members, and perhaps a lawyer to take minutes…

Everybody is trying to be the smartest person in the room…And although it’s usually done in a nice way, it can feel like a waste of time.

How do the best VCs avoid “smartest person in the room” syndrome while making an impact? Read on for tips from John Doerr, Reid Hoffman and others.

On Humility

Great board members can be helpful by asking limited but high impact questions. From John Doerr -

The best thing a good board member can do is bring 3–5 questions for a meeting, have half of those be questions the team hasn’t thought about and have one of them be truly useful. So being a good board member is not about telling people what needs to be done but asking them questions that they’ve not yet thought of.

As important as the content and intent of these questions is how they are structured. From Reid Hoffman -

When I was starting LinkedIn, I had an early board member who asserted to me with great vigor and certainty that the business model of LinkedIn would be advertising. “Reid, the game is engagement and advertising. Everything else is a waste of time. We should focus on this as an advertising business.”

In contrast, a good board member would have said: “We should evaluate the question about whether or not advertising might be our principal business model. Here are some of the arguments about why advertising might be a really central business model that we focus on. And if you have an alternative point of view, I’d like to understand that and help you drive your strategy and execution.”

The mistake isn’t disagreeing with the CEO. It’s disagreeing vehemently and unproductively without any basis in fact.

Another way of bringing humility into the board room is to speak last (which I’m not very good at).

Apparently Nelson Mandela spent meetings listening to his colleagues’ opinions and ended them by summarizing their points and offering his own, subtly steering without imposing
Speaking last gives everybody else the ability to feel they have contributed, plus you get to hear what everybody else thinks before rendering your opinion.
Sit there, take it in, and the only thing you are allowed to do is ask questions so that you can understand why they have the opinion that they have and from where they are speaking.
At the end you will get your turn.

I’m not very good at following this advice. And in fact, if you are not Chairman or the CEO of a company, it would be weird to always speak last.
But in rooms with too much brainpower, there is merit to choosing your spots and maximizing the value of what you say.

Bites #48

On deep contrarianism

Most of us are familiar with the Silicon Valley mantra (borrowed from Howard Marks) that you must be both contrarian and right to have outsized returns.

From Marc Andreesen -
It’s very hard to make money on being right and consensus. Because if something is already consensus then money will have already flooded in, and the profit opportunity is gone.

And so, in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment. And let me translate ‘non-consensus’: in sort of practical terms, it translates to crazy. You are investing in things that look like they are just nuts…The entire art of venture capital in our view is the big breakthrough for ideas. The nature of the big idea is that they are not that predictable.

If you are not investing in things that look like they are nuts, does this mean you’re doomed to median returns?

On selective contrarianism

With few exceptions, everyone thinks they’re at least somewhat contrarian.

Which they can’t be, of course. By definition, most people are the consensus they think they’re outsmarting.

Instead, what most “contrarians” are doing is balancing traditional VC pattern matching with selective contrarianism.

From Leo Polovots -
An investment doesn’t have to be contrarian in every single way, a lot of times it’s just very proven in many ways and there is one piece of it where you have to have a leap of faith.

That might be that the idea is weird and quirky but the team is amazing and there is nothing contrarian about the team. Or you can have the opposite where someone has an amazing idea but an unproven team. & then the contrarian thing is do you bet on this team early on.

So in contrarian startups there are 1–2 things you want to take a risk on and the rest should be obvious

In other words — rather than trying to outsmart everyone, VCs often limit their contrarianism to very specific team or market insights that can be validated by the next round of financing (<24 months).

Jason Lemkin puts it well -
I like to be a contrarian…but I need to make sure by the >next< round, it’s pretty darn mainstream thinking.

During times of market pullback, there is a flight to quality & a market that generally agrees with you is necessary to get portfolio companies financed. So while VCs will continue funding great companies, they will likely be “selectively contrarian”, investing in founders & ideas that are more obvious.

Bites #49

On pressure to deploy

VC funds raised a record $200B+ in the past two years.

Investment activity these past few months has slowed down significantly. Does this mean we should expect that the “pressure to deploy” will drive increased investment later this year?

Bill Gurley & Brad Gerstner are not so sure.

On the investor psychology of growth funds that have been overly aggressive these past two years -
If capital is committed but not drawn down, you’re going to have to go ask for it. If you deployed 2/3 of your fund into companies that are doing less well, are you going to go call Harvard and Penn and say hey I need some more right now?

I don’t think you’re going to make that call. These are partnerships, we are not going to put our partners in a headlock and drag them into the market.

Bottom line — they believe only 20–30% of the current dry powder will be deployed (!).

Not calling all the commitments during recessions does have precedent.

For example, check out this article from 2003 about Accel. In 2002 their LPs became impatient with the slow bounce back of the tech market and used the downturn to reduce the fund size by 30%. Those that chose not to participate missed out on one of the best performing funds of all time which included Facebook’s Series A round in 2004.

Other VCs that get caught mid-deployment in recessions sometimes voluntarily reduce their fund size.
From the same video-
In ’01 a lot of people returned the commitment, and it was actually an act of greed…they were killing the fund and getting out of the overhang, starting fresh.

Why was this an act of greed? Because post-crisis vintages tend to perform well. See Bite #28’s charts.

On reserves and roll ups

Regardless of whether LPs or GPs decide not to deploy all the recently raised dry powder — more investment dollars will be deployed into reserves in the next few years rather than new initial positions.

Some of this will involve covering pay to play / down rounds causing over exposure on deals that were not originally anticipated in portfolio construction modeling (see Klarna’s recent down round). And much of the new money will also be deployed towards rolling up distressed assets into more platform-like plays.

A move from 1:1 initial check to reserves ratio back to 1:2 by itself changes the effective amount of “dry powder” for new investments.

Bottom line
The “dry powder creating pressure to deploy” narrative is not as solid as some believe. Founders and their backers should not expect a white knight. The bar for traction and underlying fundamentals jumped dramatically overnight and those unable to catch up shouldn’t rely on any macro trends to make it easier.

Bites #51

On maintaining optionality

Old school VCs never say no.

It’s called “maintaining optionality” and founders hate it. From Elad Gil -

A firm “No,” along with a clearly articulated reason why, is the kindest way to help an entrepreneur that is fundraising.

I take pride in running an efficient, transparent investment process, which typically ends with a clear “no”. But lately I’ve been thinking about “not yet”.

Too many times, I’ve seen companies that I passed on move from “unfundable” to “oversubscribed” and kick myself that I couldn’t envision it.

Typically, I consoled myself that I made the best decision I could have given the information available to me at the time. But I’ve come to realize that these are not rare exceptions. Pivots happen, teams are re-arranged, and market opportunities arise that change a startup’s prospects for success.

So how can you position yourself to still invest in these cases without being an as*hole?

I think the key is to still be efficient and communicative (see Bite #37). Radio silence, “let me know when you find a lead” statements and endless rock-fetching DD questions are unfair to founders.

The right to optionality should be earned, through at a minimum, thoughtful feedback along with a ‘not yet’.

In practice though –

It’s awkward to tell an entrepreneur that you don’t believe they have the right CEO in place or that their market doesn’t exist (see Bite #32). Usually only the passage of time can fix these types of issues, so if you say no too soon or too definitively you are closing your opportunity to change your mind.

The answer when you can’t give clear feedback is to give clear value-add.

This demands a lot of work and therefore requires you to be very disciplined on how many “not yet” opportunities you follow. After all, “call options” cost money, and they require founders to agree to accept your investment when the tides turn for them.

Bites #52

On down rounds

The NASDAQ is down over 30% YTD with no end in sight.
And yet, according to Pitchbook’s Q3 analyst note, only 6% of startup financings through Q3 2022 have been down rounds.

Why hasn’t the VC market adjusted to the current climate by just lowering startup valuations?

From Frank Rotman -
“Just let it correct” isn’t as easy as it sounds. Have you ever suffered through a down round? Have you seen what happens when employees have underwater options? Do you understand what it takes to claw out from under a preference stack? This is the definition of pain.

Are down rounds as destructive as we tend to believe?

Not necessarily.

From Jason Friedburg in the All-in podcast back in Jan -
If you look at the public markets, every successful company has had significant downturns in their stock for significant periods of time, from Apple to Facebook to Amazon. There were perturbations in markets and in the business, but all of those businesses were sound and the long-term value creation was still there.

I’d argue that in some cases the fact that there are investors willing to lead down rounds should serve as a signal that there is value in a company.

From Micah Rosenbloom -
Unless a startup has made substantial financial progress or has developed easy-to-value technical assets, “down rounds” aren’t worth the trouble for most VCs. Recapitalizing a startup requires the new investor to balance the legal rights of the existing cap table, resetting the expectations of employees, and their own needs — it’s almost always easier to fund a new startup.

Looking at the glass half full — nobody would bother leading a down round in a company unless there is significant IP or revenue. And in fact this seems to be supported somewhat in the data.

According to Pitchbook -
Just 13% of companies raising a down round from 2008 to 2014 were unable to raise a new round or exit immediately after the down valuation investment…For those exits that we do have information on valuation, 88.1% were at a step-up from the down round.

Companies these past few months seem to be primarily concerned with optics, looking for creative ways to extend runways by issuing debt, like convertible loan notes, to tide them over until the market improves.

But those VCs with experience are advocating dealing with reality.

From Brad Feld (part 1 & part 2) -
I learned this lesson 127 times between 2000 and 2005. I watched, participated, and suffered through every type of creative financing as companies were struggling to raise capital in this time frame. I’ve spent way too much time with lawyers, rights offerings, liquidation waterfalls, and angry/frustrated people who are calculating share ownership by class to see if they can exert pressure on an outcome.

When you have a choice between a financing at a lower valuation and a financing with all kinds of crazy structure to try to maintain a previous valuation, negotiate the best price you can but do a clean financing with no structure.

Bites #53

On the economy

How much energy should we as VCs expend trying to understand the macro economy?

From Brad Gerstner -
“Most fundamental investors say “Oh I’m not a macro investor, I don’t know where inflation or interest rates are going, I just find good companies.”

We’ve had a decade+ where that was ok to do. But when you have massive volatility, it’s not acceptable as an investor just to say “well none of this matters”.

Price does matter, because what you can exit for is essential to the game. Multiple expansion hides many sins, and now the opposite is happening in a dramatic and historic way.”

On the other hand, it’s tough to predict the future.

From Brian Singerman @ Founders Fund -
“I don’t try and predict macroeconomy, period. I don’t try to be one of those VCs that sits there and says, “oh the funding environment is going to be bad for a long time” or “it’s going to get better!”.
Nobody knows.
My partner Peter Thiel is a brilliant macro economist and probably the best at the business at this and even he can’t predict it.”

Is there an option in-between ignoring cycles vs trying to know it all?

From Howard Marks’s book “The Most Important Thing” -
“Market cycles present the investor with a daunting challenge, given that ups and downs are inevitable, they will profoundly influence our performance as investors and they are unpredictable.

So we have to cope with a force that will have great impact but is largely unknowable. What, then, are we to do about cycles?”

He goes on to say -
“First, we must be alert to what’s going on. As difficult as it is to know the future, it’s really not that hard to understand the present. What we need to do is “take the market’s temperature” and use that to try to figure out where we stand in cyclical terms as well as what that implies for our actions.”

He offers a checklist of specific questions you can ask yourself such as
- Do the media talking heads say the markets should be piled into or avoided?
- Are novel investment schemes readily accepted or dismissed out of hand?
- Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls?
- Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?

He offers a more detailed check list in the book (buy it here).

Assuming you are able to accurately gauge the market temperature, how can you translate that to action?

As the market was heating up, “being alert” meant filling the tank & taking money off the table.

In the current market, this recent quote from Bill Gurley seems to reflect the temperature well -
“In a couple meetings, I’ve heard an owner or founder say, “Well, you know, we just need to buckle down until things get back to where they were.”
And I’m, like, “No, the fantasy was the past five years.” What we’re in now may just be normal, right? This may be average. And that’s very hard for people. It’s especially hard for a founder.”

In terms of that means for us as VCs, taking from Brian Singerman -
“It’s good to pay attention because you can’t pay ridiculous prices as that will limit your upside. But just don’t try to predict it…
To me I’ve never been able to be convinced that we should be doing anything other than putting the most money into the best companies possible at the best possible prices. I don’t really know what to do differently.”

Quality companies are not desperate for capital right now, but they are certainly humbler than in 2021. When there is no agreed upon standard price, that’s potentially a great time to mutually explore if win-win deals can get done.

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Jonathan Friedman

Partner @ LionBird Ventures, sharing my thoughts on the “VC Point of View”