How Venture Capital Works. Part 3: Investment Thesis
How does VC make a decision?
VC’s General Partners (GPs) are asset managers. They do not make any random investments. They will only invest in the industry and company that they believe in. Every single investment needs to be backed by a rational logic for the Limited Partners (LPs) to comprehend. In this article, I will illustrate the logic behind an investment decision. This will be a piece of valuable information for startup founders as you could take a peek on what happened behind the closed door.
P.S. Find the previous article: How Venture Capital Works. Part 2: Business Model in this link.
Investment Thesis
Definition
This is the overarching strategy of a fund. All investments need to be justified by the investment thesis.
Do you have any goals in life? How are you going to achieve that? If you assume a fund as a person, his purpose in life is to maximize shareholder value. That’s the sole purpose of his life. Then, how is he going to achieve that? He needs to have a plan and that plan is called the Investment Thesis.
A venture capital Investment Thesis is an overall set of beliefs a fund uses to determine whether or not to make a particular investment. A fund’s Investment Thesis provides a written guideline of when to take an action and why. An Investment Thesis may be presented either in written form or can be as simple as an idea. (1839Ventures)
Investment Thesis is unique to each fund, not firm. A firm could have multiple funds, but each fund could only have a thesis. 500 Startups describes its investment thesis for its early-stage fund as such:
Invest BEFORE Product/Market Fit, Double-Down AFTER.
Composition
For me personally, an investment thesis is a method for the GPs to take their abstract thought into a written form. GPs need to “download” their thought and then “upload” it to LPs’ minds. Investment thesis consists of four crucial elements:
GP’s Acumen
A fund will only as good as its GPs. GPs are usually industry veterans or entrepreneurs who have endured multiple failures and successes. They will develop a “sense” to predict the future of the industry and assess the potential of a founder.
Market Research
An investment thesis should be backed by market research. Do the data agree with the GPs’ acumen? Otherwise, it will only be a hunch and will be hard to defend. This job is usually given to the associates. They will do both desk and field research to gain accurate data. This is what I label as “testing the water”, i.e. meeting a founder not for an investment opportunity, but for a data-gathering purpose.
Pattern
Human recognizes patterns naturally, even when none exists. It is our instinct. That’s how we survive as a species. After the market research, associates will try to find a pattern and apply it as a formula to the desired future. E.g. This pattern has happened in the US, China and India, so let’s repeat the formula in South East Asia.
Take a look at South East Asia’s unicorn. Could you name another company with a similar business model to Grab or Gojek? You guess Uber? Bingo! What about Tokopedia or Bukalapak? eBay. Investors, especially in emerging regions are usually more comfortable to invest in something that has a “Global Equivalent” which allows them to see a pattern in their investment.
Investment Strategy
Lastly, a strategy is devised based on those prior things. Take a look at 500 Startups strategies below.
INVEST EARLY at LOW COST in people you think are smart and have built some promising products. Understand if they know how to iterate and use customer feedback to improve their product and/or marketing. learn how to understand conversion metrics for their business & customer value. Then IF you see the metrics improving & customer/business value increasing… then DOUBLE-DOWN.
“Investment Thesis tells me why I would want to own this business.” Joe Trustey, Summit Partners.
Applying this knowledge
So, how could you use this knowledge for your fundraising process?
Understand your industry macro
Is it a growing or declining industry? How big is the market size? Investment is about timing and Venture Capitalists would like to ride the early wave of that growth. If your industry has reached its peak and stagnating, you will have a harder time raising funds even with an amazing product in hand.
Research VCs’ investment thesis
GPs will rarely stray from their investment thesis. If you are not suitable for the fund it is better to move on and find another. Ask them explicitly upfront about their thesis. Do you suit the picture? Investing is like a marriage. You cannot extract a fruitful marriage if the couple doesn’t share the same value and vision. Your investor will come eventually. You just haven’t met them yet. Keep searching and hustling until then.
Adjust your pitch
I won’t suggest you change your startup’s vision. It will compromise its integrity. However, you could sometimes adjust your selling point or industry by a bit. E.g. adjusting your marketing to grab more SME’s customers to be qualified as an impact startup or more banking clients to enter the rising fintech industry. It’s not about being a fake, but it’s always a good idea to dress up for a date isn’t it?
Thank you for reading! In the next series, I will write about the “Anatomy of a VC”. Have you ever wonder who has the decision making power and what can you expect from each person from the firm? Happy to hear your thoughts! Let me know your comment and please share if you find this article useful. You could connect with me at linkedin.com/in/erikhormein/.
