Momentum vs. Value-Based Investing in Venture Capital: The Power of Conviction
Why betting on a founder’s persona is a better strategy to deliver venture returns
Watching the continuing IPO galore and Series A valuations uptick got me thinking about two central approaches I see to early-stage venture capital investing, and where my own investment philosophy fits in: momentum-based vs value-based investing.
While the former represents a dominant and attractive strategy on a surface, its effectiveness can prove illusory, with overblown successive valuation generating unrealistic growth expectations and disappointing returns. Resisting getting caught up in the hype cycle and betting instead on one’s conviction around founder’s persona and her unique relationship to the problems she seeks to solve may not be as popular, but pays dividends in the long run.
The Siren Song of Momentum
But let’s go back for a second: what exactly are these two approaches, and why does it matter? Momentum-based investing is a strategy to capitalize on the continuance of an existing market trend, with hallmarks of higher price per share, oversubscribed rounds, higher initial on-paper returns but weaker negotiation leverage, and super limited timing to conduct due diligence.
Though appealing at first blush, these returns can be short-lived: they tend to be based on startups leveraging momentum to raise more and more capital spurring higher and higher valuation, thus impacting previous backers’ price per share. Having too much money too soon is blinding, however, and damaging for VCs and startups alike: a large early cash infusion tends to come with extraordinary demands for growth, forcing founders to focus on short-term performance instead of sustainable long-term growth.
This strategy also requires tons of liquidity, as we can see in the example of a16z investing in Clubhouse, which doesn’t generate revenue yet, at $100m valuation in Series A and at nearly $1b valuation in Series B after winning the deal from the likes of Benchmark. And while this approach’s appeal is bolstered by success stories like Facebook’s acquisition of WhatsApp for $21.8b or $55 per user, in reality, these examples are anomalies, even given a big power law distribution. Recent prevalence of momentum-based investing is a powerful signal of a growing interest misalignment between GPs of large multi-stage firms and their LPs (keep an eye out for a future post in which I cover this in more depth).
Not all expensive companies are great. All eyes on Fit.
In contrast to the momentum-based strategy’s focus on current market and valuation trends, value-based investing is guided by a high degree of conviction in the founder(s) and their approach — informed by the ultimate desire to support someone you truly believe is the best person in the world to build what she is building. It’s driven by a focus on founder fit with both market and investor, instead of just getting a piece of a hot company.
When I consider investing in a certain founder, two questions guide my judgement:
What is the founder’s personal connection to the problem?
There is no better teacher than firsthand experience, and founders who can connect with an issue from a place of being personally impacted by it have a distinct advantage in devising and executing effective solutions. A personal connection to the problem and/or industry can also often be a motivator towards success and long-term commitment.
As an immigrant twice over and a working mother to three young daughters, I exemplify this last point myself. I moved to Singapore from Russia in 2013 and lived there for 4 years, during that time I actively invested in the Southeast Asia. Cumulatively, I’ve spent 10 years investing in emerging markets before I moved to and settled in the US in 2017.
My experience as both an immigrant acclimating to a new environment and as an investor in companies in emerging markets gives me unique insight into the strengths of and challenges faced by immigrant founders and those working outside the US and Western Europe. In addition, my commitment to creating a world for my young daughters to thrive has forged my deep personal motivation to help women entrepreneurs realize their true potential and succeed big.
Why are they uniquely qualified to change given industry?
I lean on the degree to which a founder’s genuine connection to the needs of a particular community or industry have given them a deeper understanding of the pain points of the specific customer base. In my experience, such understandings give founders a solid competitive edge and helps develop unique customer-specific acquisition strategies.
Overall, these problem-solvers represent a much more diverse pool of founders than that of tech entrepreneurs as a whole. They’re typically people who are drawn to solve issues facing underserved markets of which they are part, and are both willing and equipped to do so in an industry environment that often gives them the short shrift.
Additionally, cash-deprived founders are more creative — as are emerging fund managers, whose management fee is often barely enough to make ends meet. This creativity and resulting sustainability and efficiency of growth leads to better performance on both ends of the spectrum.
“Entrepreneurship by necessity” mindset paired with initial lack of staged capital available fueled the growth of tech ecosystems in a number of emerging markets including Brazil and Mexico. On the fund mangers’ front, as infographics in this article show, emerging managers and smaller funds tend to outperform established funds — and have done so consistently over the past 15 years.
Digging deeper into these questions highlights powerful parallels between entrepreneurs and first-time fund managers: we understand one another and have similar goals, which can be leveraged into mutually productive investment partnerships. Emerging managers are entrepreneurs in venture capital who need to differentiate themselves against the pool of other managers to win LP commitments.
One great way to do it is to focus on a particular founder profile or market niche that resonates with their life and work experience. Interestingly, this alignment of backgrounds and personalities starts a flywheel by helping emerging managers win competitive deals through being a better match (which is the hardest part of venture capital) and stand out to attract world-class institutional investors.
Speaking about perfect match, my investment approach is the product of my own life experience. I tend to bond with diverse founders, females and immigrants from emerging markets with strong survival instinct, thick skin and unstoppable desire to address massive societal needs here and now just because I understand these categories of founders better and can relate to their hustle.
Final thoughts
The sky is the ceiling for daring entrepreneurs: there are so many dysfunctions in the world in dire need of effective solutions. Likewise, bold emerging fund managers willing to think outside the box have the potential to make an outsize impact on our society through finding and funding overlooked entrepreneurs who are at the forefront of furthering technology and operational excellence.
Many of the industries which hold the most potential for founders and funders willing to bet on solutions for underserved markets are neither viral nor sexy (at least until they hit momentum); they are overwhelmingly bureaucratic, heavily regulated, and often require investment in market education and constant product customization. Yet for those inclined to look past the splashy startup hype cycle and invest in promising founders with an innovative vision for the future, the rewards can be bountiful.
