February 2016 was one of the highlights of my 2016. I had a chance to join a wonderful team of people from the venture capital world, where we tried to unlock the secrets of venture investing, learning from some of the phenomenal speakers and thought leaders in the industry such as Dave McClure, Bedy Yang, Christine Tsai, Mike Lyons, Pedram Mokrian, Tim Draper, Mark Suster, Aydin Senkut, Elizabeth Galbut, Mike Lepech, Jason Calacanis, and others. The Venture Capital Unlocked program was led by 500 Startups in a partnership with Stanford University.
In this article, I want to focus on one of the most important — yet often overlooked — aspects of a successful investment strategy: investment thesis.
INVESTMENT THESIS — DEFINED
An investment thesis is an investor’s individual strategy which helps determine which companies to invest in. It is a roadmap that disciplines an investor to invest only in the companies that conform to one’s individual investment philosophy. It’s also a clear indicator to startup founders of what type of investments particular investors are interested in.
For an investor, the good thing about defining an investment thesis is that it is actually not that difficult! There are a few aspects you should focus on, depending on your experience and motivations, but you absolutely need to have one before taking the investment plunge! It forms the foundation of your investment philosophy and will help you succeed as an investor. The following sections outline factors to consider when deciding where to invest.
Investing in the right industry can make a big difference. There are many industries you can focus on — enterprise software, e-commerce, digital healthcare, consumer services, biotech and FinTech — to name just a few. To increase the chances of investing in a startup that will succeed, you should have a solid expertise in the field in which you plan to invest. Also, having an understanding of the market trends in the industry, as well as connections to key players is crucial, as it ensures that you don’t miss the right train, see the big picture, and add value to your portfolio investments.
Usually, VC firms rarely invest only in one domain, but rather form a macro-thesis around big picture trends and types of investments that will lead the path of innovation in these areas. For example, the focus of SoGal Ventures, the first female-led millennial venture capital firm, is focused on how millennials work, consume, and stay healthy, so they invest primarily in Enterprise SaaS, Digital Healthcare, Consumer Technology and Global Products and Services. Additionally, in their due diligence process, they are heavily focused in evaluating the design approach of the startup, as well as the diversity of the founding team.
A clear vision for the future of the world blended with an investor’s unique perspective and expertise, creates a differentiated and precise investment thesis that helps increase the likelihood of investing in a big win.
Many startup founders may have a good idea, but proper execution of the idea is what really matters. One of the most important factors to consider is the startup team. An investor should evaluate the track record of the team when assessing an investment candidate. Some investors think that having teams that have previously worked together is a big plus, as it shows that they know how to stick together when things get difficult. Others may be strongly opposed or strongly supportive of investing in companies in which the co-founders are in a romantic relationship, especially if not married. These types of preferences vary by the investor, and is something that is usually driven by previous great or awful investment experiences.
Another aspect to consider is the domain expertise of the team members. Questions investors (should) ask include:
• What are the founders’ backgrounds?
• Do the founders have a successful track record in the particular industry they’re targeting?
• Are the founders’ capabilities aligned with the company’s execution requirements?
• Are the founders passionate about the current endeavor? Do they effectively convey and communicate this passion to others?
• Do the founders have the persistence and tenacity to push through the tough times when it seems as though there is no light at the end of the tunnel (which often does happen)?
It’s also important to take a thorough look at the startup’s leadership. While some investors are comfortable with co-CEOs, according to Thomas Korte, the founder of AngelPad, it should be very clear who the ultimate decision-maker is. It is important to notice if the named CEO does not actually seem to be running the show. Yes, it is great when a CTO comes along to help pitch the technical details, but the CEO should be leading the fundraising process and should know enough about the technology they are building to communicate it clearly.
Furthermore, understanding the startup’s team dynamics is essential. Founders breakups are one of the top causes of early stage startup failure. Questions investors often ask include:
• Does the team seem to work well together?
• Do you sense any sources of tension or discord?
• When talk, do they often speak over one another?
While the team members certainly do not need to be best friends, they should demonstrate a basic respect for one another, and have good communication skills. An investor should be wary of situations where the relationships between team members do not seem harmonious. Think long and hard about what your gut might be telling you about the team before you invest.
Remember that your investment signifies that you are willing to spend a lot of time with this team; if there is something that does not feel right, it will affect the whole working relationship, and most likely the investment outcome as well.
You need to determine the optimal stage of the company you are considering for investment. Usually, investing in later stages means less risk but also lower returns; in this case, the startup most likely has had previous investors and must be doing reasonably well to be seeking a new investment round. Investing in later stages also means that your share in the company will not get as diluted by additional investment rounds as it could be for a seed stage investor. But, these deals can often be hard to participate in. As an investor, do you have the network and amount of capital to get in on the hot deals?
Some investors prefer to invest in earlier stage startups, when the company’s valuation is lower. In this case, you need to conduct a more thorough research on the project and make your own determination as to whether the company is likely to succeed. You also may want to invest in a larger number of startups — a philosophy followed by many venture capital firms, including 500 Startups — to ensure that your risk is diversified.
What are the upper and lower limits for your investment? These amounts typically depend on the size of your fund if you’re a VC, or your personal net-worth if you’re an angel investor. Thus, a $25M fund, may investing in 40–60 startups in the $250K range or 15–30 startups in $500K range, leaving necessary amounts for possible follow-on investments, if needed. These numbers also depend on the investment stage of the company, discussed above.
CO-INVESTORS & PARTNERSHIPS
Will it matter to you who are the other investors in a round? Having co-investors who have a proven record for identifying successful companies and adding value such as Sequoia, Accel Partners, Felicis Ventures and DFJ Venture will increase the chances of identifying the ‘right’ startup. Investing in companies that have gone through accelerators such as 500 Startups and AngelPad will increase the chances of identifying future big exits as well. This is because the companies that were selected to join the accelerators and that received support, training and advice from these big players have a better chance to succeed. If you decide that the profiles of the co-investors and partners are a crucial part of your thesis, the bottom line is to co-invest with firms and people that have access to the most curated deals and attract the highest-talent startups.
There is a wide range of questions to ask regarding the company’s target market. It’s also important to drill down and understand how the entrepreneur thinks about their market segmentation and how this fits into your own investment thesis as an investor. Questions to ask include:
• Who has the team identified as their ideal customer?
• How costly will it be to acquire new customers (CAC)? Is this cost greater or less than the average lifetime value of the customer (LTV)?
• Is the team focusing on emerging sectors of the market or on more strategic plays?
• What is the company’s geographic focus? Is it local? International? Today many investors look for startups in international arena, rather than only in ‘hotspots’ such as Silicon Valley or Silicon Fen. According to Aydin Senkut, the founder of Felicis Ventures, focusing on a broader geographic region gives more opportunities to find right startups.
Conversely, if you believe that there are whitespaces or untapped opportunities in the market that the current established firms aren’t paying attention to, this can be a phenomenal opportunity to invest and arbitrage the current market conditions. A number of newer VC firms are taking this approach. For example, 500 Startups focuses on investing across the globe in untapped markets, and SoGal Ventures focuses on investing in highly-talented diverse founders. At the end of the day, only you can decide which of these attributes are most important to you within your individual investment paradigm.
What are the trends in the industry in which you are considering investing? Are there regulatory conditions or potential changes you need to be aware of? For example, in the FinTech industry, changing regulatory conditions are enabling faster growth in certain countries over others. In context of your investment thesis, take time to research user expectations in the industry, consider what might be the “next big move” and whether the product or service you are considering for investment fits in with this potential change.
Although each of these categories is important in making investment decisions, depending on your investment thesis, some may be more heavily weighted than others. Once you have considered which of these factors will be key to your thesis, your investment thesis will begin to take shape. As you broaden your investment activity, be sure to keep circling back to your original investment thesis to be sure that potential investments still conform to your original requirements. If not, take a step back and see whether you need to modify your original thesis to be more in tune with your current way of thinking. Whether it remains as is or continues to evolve, your investment thesis will be an invaluable asset in ensuring the relative safety of your investments, both now and in the future.