I was chatting with Nick Chirls from Betaworks recently and we talked a bit about Angelist syndicates and the incentives surrounding it. Betaworks was one of the first investors to use Syndicates on the platform in their investment with Estimote (a really cool company, BTW).
Nick reminded of an interesting perverse incentive that syndicates creates. Note, this IN NO WAY drove Betaworks’ decisions in this case, but he just pointed out that these incentive will exist almost by definition of how syndicates works. Essentially, Angelist syndicates creates an incentive to:
- Invest a little less
- Be less price sensitive
- Have a lower bar
Why? The answer is a) “free” leverage on one’s dollars and b) deal-by-deal carry.
On a), this drives the price sensitivity. As an investor, you are essentially now able to get more of an economic interest in a company than before on the same dollars. Thus, you are on balance more tolerant of risk (thus lower bar) and can get the same financial outcome even if you invest at a slightly higher price (thus less price sensitive). Or, another approach is to say that you can now get the same economic interest with a smaller investment (this, invest less).
The other (and to me, the bigger) issue here is the incentive around deal by deal carry. In early stage investing, deal-by-deal carry is awesome for the person doing the investing (the VC or the angel), and is pretty bad for that person’s investors. Almost no early stage funds have deal-by-deal carry. The reason is that the riskiness of early stage investing means that one has to build a portfolio of investments to be successful. Our profits in this portfolio of investments drive our carry in the fund.
But obviously, a VC or angel should be required to return their investors’ capital first before really earning that carry on the profit. However, this is not the case with deal by deal carry. You can lose money overall, but earn a nice chunk of carry along the way.
Simple example: Let’s say I’m a $10M fund. I invest in 10 companies at $1M each. If 9 completely fail and 1 makes a 9X return, I have returned $9M of the $10M. I earn no carry.
Now let’s say I’m an angelist syndicator. Let’s say I make a small investments in 10 companies, but attract $1M in syndicate capital for each of those companies. So, it’s like a $10M fund. If 9 fail and 1 makes 9X, I am able to get a carry on that 1 9X return. So, if I charge a 20% carry, I make 20% x $8M, which is $1.6M (of which Angelist takes a cut). That’s pretty awesome when my overall performance was actually a loss of capital.
Of course, because each syndicate has different investors, there is no way to force me to pay back my overall principal before taking carry. But the incentives in this situation is for me to be more risk loving overall. And if I can get really good leverage on my dollars, I could basically write pretty small checks into a lot of companies, but bank on the beautiful benefits of deal by deal carry to save the day for me.
This should come to roost at some point, because over time, syndicate members will stop following an angel who loses money on average. But this won’t happen very quickly as long as I catch a hot deal now and then. Even if I lost money along the way, but got a 20X on one investment, I think that one 20X would be enough to attract more capital behind me for a few years. Obviously, not all actors on angelist are going to do unnatural things because of these dynamics (the best definitely won’t). But these incentives definitely exist and aren’t great for a “follower” on angelist, or for any investor in any early-stage fund that gets deal-by-deal carry.
I think Nick is going to have some specific thoughts and reactions to this, so I look forward to continuing the discussion!
I continue to be on a kick towards better and more systematic decision-making.
One exercise I’ve tried is to codify my mental decision-tree for early stage investing. Essentially, it is the internal dialog I tend to have with myself when evaluating companies. But by charting it out, it helped me to be more explicit about what attributes I’m looking for, and how my opinion about different attributes feeds into an ultimate decision.
Rather than replicate the entire decision three, I thought I’d share just a flavor. The first high-level questions I ask are:
1. Is this an awesome founder?
2. Is this a market I want to have an investment in? This incorporates both the total size potential of the opportunity and the attractiveness of the market itself.
3. Is there strong founder market fit? Is this an authentic idea, and does the capability of the founding team map well towards the needs of the market in the early stages of the business?
Here is the tree with some commentary on the different combinations below.
So, a couple combinations:
- If 1 = yes, 2 = no, it’s usually a no. I’m generally a believer that markets beat teams. But that said, I’m actually typically very open minded about what markets I’d like to have an investment in.
- If 1=yes, 2=yes, and 3=no, I think it’s difficult to invest pre-product and before some evidence of product/market ft. I think founder/market fit is incredibly important early on. We have invested in some companies of this profile where we loved the founder but our perception was that founder/market fit wasn’t that strong (ThredUp is a good example). But in those cases, very early metrics went a long way towards mitigating the risk.
- If 1=YES YES YES then we might still move forward early on. Basically, this is the rare (0.01% of less) exception where you feel like you have HAVE to back a truly extraordinary founder. In the case where this extraordinary founder is pursuing an unattractive market, we need to ask ourselves, is this founder wrong about the market, or could we be wrong?. We still tend to have a bias that markets tend to win, but we will dig to figure out if we aren’t missing something. If the market is attractive and there just isn’t great founder/market fit, we will be open minded as well. There are just some rare entrepreneurs that you want to be in business with in almost any circumstance. But it’s definitely a very small minority. Jack Dorsey comes to mind here with Square. Not exactly founder/market fit, but it didn’t really matter.
- Sub-point: Actually, in a way, Jack did have founder/market fit with square because of what the company required. His personal brand and influence in the technology industry enabled him to raise large amounts of capital with relatively little traction and get to the very top of all major financial institutions, both pretty important advantages in starting a payments company of this sort.
- If 1 = Yes, 2 = yes, 3=yes, then I’d seriously consider investing pre-launch. This isn’t a formula by any means, but I find that when founders I really like are going after an authentic idea in a space I like, I’m much more willing to jump in pre-product. This describes quite a few of our portfolio companies actually. Not all will work out, but in many cases, I feel perfectly fine about having taken the plunge.
- If 1 = No, 2 = yes, 3=yes, then I’d need to see some evidence of product market fit or traction. Even then, it’s really hard to get excited about an investment unless I’m really excited about the people leading the company. But I am also congizent that how one comes off in a fundraise is not always perfectly correlated with their capabilities – and there is something about delivering results that makes you think twice about your first impressions of people. If the reason that 1=No is because of any fear of integrity or something similar, then it is really a no-go. But if it’s more of a question about capabilities, then it’s important to stay open-minded. It’s easy to underestimate people.
Of course, there is a lot more going through my mind, plus some really important “softer” considerations that are beautifully articulated by my old colleague Bijan here. The point of this post isn’t to say that this is the right way to do things or to say that I follow this approach strictly. But I did think it would be interesting for founders to see an attempt at simplifying what is usually the black box of an investor’s mind.
I’ve been hearing a similar lament recently from founders of seed stage companies. It goes something like this:
“I thought seed funds would be faster at getting to a decision than large funds. But I’m finding these guys are actually pretty slow, and do so much work vs. some large funds that make decisions surprisingly quickly.”
I’ve been thinking a lot about deal selection in Venture Capital, so this meme is particularly interesting to me. Here’s what I make of it.
Many seed funds are getting slower in decision-making. This is good in some ways, but bad in some ways. Here’s why I think this is happening
- More seed funds are realizing that they need to have more concentrated portfolios to generate good returns. In other words, these funds need to be pickier, choose their spots better, and say “no” more. By definition, this means that they will work harder to build conviction around an opportunity and move more slowly. This is good because when you get a “yes” from a seed fund, you are more likely to have a partner who has thought deeply about your business and be in a better position to help. In theory, this could turn a 3-7 day process into a 7-15 day process. Still reasonably fast in the scheme of things.
- Many seed funds are growing up, which is leading to more distractions and more reasons to be slower and more pessimistic. Many of these investors have larger portfolios now, which is a major tax on time. These investors have come face to face with more companies that have failed or are struggling, especially in the wake of the series A crunch, so the problems with early stage companies are more salient than ever. This leads more seed funds to approach investments with a defensive mentality vs an offensive one. In early stage investing, offense wins.
- Many seed funds are expanding their teams. What used to be a 1-person show now involves multiple investors, and potentially multiple levels of professionals. These firms are working through how to best collaborate as a team and drive to efficient decisions quickly. But in the meantime, this additional set of people adds complexity and friction to the decision-making process.
- Many seed investors don’t lead or have limited experience leading. What they’ve found is that it’s reasonably effective to hang-around-the-hoop as a deal is coming together, and pounce once a high-quality syndicate seems to be forming. This leads these investors to not drive aggressively towards a decision, rather keep a conversation going slowly to maintain optionality if/when someone really good does decide to lead.
On the flip side, large funds move faster than many would think. It doesn’t always seem that way, because just like seed investors, large funds will “hang around the hoop” on many of the companies that they like but are not chasing aggressively. But they can move pretty quickly driven by a few reasons.
- Some partners at larger funds just have tons of experience to draw from and enough political capital in their firms to make stuff happen quickly. I was having breakfast today with a partner at a large, top-tier venture fund, and he remarked that one of his colleagues, who is over 60, is in the “prime of his career”. And what impressed him most was the speed and decisiveness of his thinking. If you are talking to the right partner and your company is right in their power alley, you could have an extremely fast process
- The level of competitiveness among larger funds is ridiculously intense and has only been getting more so. This is probably less true at the seed stage, but that intensity has spilled over into all segments where these firms invest. This increased competitiveness has forced these funds to figure out how to be agile. I find that the “best” funds often are also the ones that drive fastest to a decision, and compress a fair bit of work into a short amount of time if they are really serious about an investment. I’ve often heard entrepreneurs remark positively about the speed of great funds. I’ve never heard an entrepreneur remark positively about the speed of mediocre funds.
- Some funds continue to do high-velocity, passive seed investments. These investments have the signaling risk that has been talked about ad-nauseam. These investments also have a separate process, by which one or two partners can decide to pull the trigger, without necessarily getting full partnership buy-in. In this case, I see speed as a negative signal, not a positive one.
Overall, I’m a believer that VCs can and should make careful but fast decisions. You can do a lot of reference calls and market due diligence in 3-7 days. The trick is to make the decision up-front to clear one’s schedule and do the work, with the goal of driving to an independent decision. In an ideal world, this allows everyone to win. Investors make good decisions. Entrepreneurs get investors that have well informed opinions and high conviction around their companies. And this can get done in a reasonable amount of time so founders can keep their foot on the gas and keep building their companies.
I’m often asked to share advice about raising the first few rounds of capital for a young startup. I’m actually on my way to an accelerator right now where I was asked to lead a few sessions on this topic.
There is a ton out there on the internet about the tactics of raising money. Paul Graham wrote a really comprehensive essay a few weeks ago that mirrors most of the advice I tend to give. Read it here.
But my over-arching observation is that fundraising is extremely unpredictable.
This is pretty puzzling to most people. One would think that fundraising could be a pretty rational process. Pick the 5-8 firms that seem to be the best fit, get a good introduction, focus on the 2-4 that really dig in, and go from there.
I’ve even seen series A firms give this general advice to their portfolio companies. ”Run a small process” and see what happens. The thought is you can always talk to more folks later.
From my perspective, this is typically pretty bad advice. The conversion funnel above is accurate, but only mid-way through your funnel. The top of the funnel needs to be much larger to have an effective fundraise.
This is because there are so many reasons why VC’s can pass on an investment, and it’s pretty impossible to really account for all the variables prospectively. Here are some examples:
- No experience in the space
- Bad experience in the space
- Partner had a bad experience in the space
- No comparable companies have been acquired recently
- No comparable companies have gone public recently
- Comparable company had an IPO that tanked
- Consumer is out of favor
- Enterprise is out of favor
- Too capital efficient
- Too capital intensive
- Great early traction, but I don’t see how it gets big
- Big idea, but you should start with something smaller to prove traction
- Great traction, but engagement is bad
- Engagement is great, but it doesn’t matter without traction
- The team is unknown
- The team is too well known
- Partner just did a deal
- Partner is dealing with tons of issues with their portfolio
- Partner has personal issues
- Partner is about to join another firm
- Annual meeting prep is taking too much time
- Fundraising is taking too much time
- There is some wierd conflict that is impossible to uncover ahead of time
- Wife thinks the idea is bad
- etc etc etc
This is just a subset. But there are many more. Maybe when a company is further along, the realistic set of investors is smaller, and a relationship has been built over time that allows for a narrow scope. But early on, in the seed, Series A, and even the Series B round, I think it behooves founders to assume a 50% factor of unpredictability, and double the number of groups they plan to talk to. Then as Paul Graham says, run a breadth-first search and parallel process. Ideally, you’d like to get to a point where you have 6-8 potential leads really digging in mid-way through your funnel. So get there, you need to have 2X the number of really quality conversations in the beginning, which probably means that you need another 1.5X the number of potential investors before a bunch of firms get disqualified for one reason or another.
There may the concern that your round seems “shopped” and can get stale if everyone knows you’ve been raising money for a while. This is the reason to do things simultaneously rather than sequentially. It’s very natural to think “I’ll focus time on my 4 best prospects, then if those don’t look good I’ll move on to my next 4, then so on. Don’t do this. You have to parallel process.
I now that sounds like a lot. It is – and you will feel like a maniac during this process. But if you are honest with yourself about how investors are receiving your story and triage the funnel appropriately, you can accurately and quickly hone it down to the smaller subset of serious prospects pretty quickly. But it is almost always beneficial to put in the shoe leather to do this because I guarantee that one of those serious prospects will be a group you didn’t expect to be in the mix when you started fundraising.
Source, Select, Win. Those are the three activities that all VC’s do.
Ask 10 VC’s which of the three is most important, and I think at least 9/10 would say “Source”. If you don’t see the best opportunities, there is no way selection and winning (both winning the deal and helping the company win) will produce the best returns.
I’ve historically agreed with this, but my thinking is shifting. Selection is totally underrated, and is only getting more important.
It’s interesting to me that selection is under-appreciated compared to sourcing, because many VC’s see the same deals but have such wildly different outcomes. And the misses aren’t just the deals they they failed to win – many are the ones they passed on, or just didn’t chase aggressively. This is only becoming more common as entrepreneurs are getting smarter about fundraising, and more transparency exists in how companies are doing.
I also find this interesting because almost all VC’s say they look for the same things in companies. Great teams, transformative opportunities in attractive markets, and excellent products. Economically, most VCs also realize they are incentivized to look for “home run” investment opportunities – ones that have the potential to generate a meaningful return to their funds. In other words, companies that can generate hundreds of millions of dollars in revenue and ultimately have billion dollar enterprise values.
And yet, VCs look at the same investment opportunities so differently. They “swing at different pitches“, as my friend Eric Paley puts it.
So, is selection such a black box? It seems that way. These companies are so early, and most are likely to fail, so of course, many smart people can see the same opportunity 20 different ways. It comes down to “judgement”.
That doesn’t sit great with me. Maybe it’s my “J” personality. I’m increasingly of the opinion that just like sourcing, investors can hone their machine when it comes to investment selection. And it’s only getting more and more important. Here are some ideas I’m thinking about and exploring.
1. Team Selection. This is a process that tends to be very ad-hoc and based on feel and gut. Investors that have been in the business for decades have a bit of a sixth sense when it comes to great founders.
And yet, I’ve seen that sixth sense fade as well. I think certain entrepreneurs tend to thrive in certain environments and certain times. The classic entrepreneur that you wanted for a telecom equipment company exhibited totally different attributes when the most interesting opportunities moved up to the application layer. So pattern recognition tends to fail when there is a large market shift, which, arguably, is the time when you want to be most aggressive.
I think there are opportunities to be way more methodical and data driven when evaluating founding teams. By methodical, I mean having a real rubric by which to evaluate founders for certain types of companies and intentionally hunting for those attributes (or finding they aren’t there). By data driven, I mean looking at real data across many many companies and trying to draw the information that informs that rubric. For example, this.
For additional reading on this topic, check out this great article at the FRC review from Neil Roseman on Technical Hiring at Amazon.
2. Data Analysis. Every investor has some set of data that they know cold that informs their opinions about certain types of investments. Every senior exec at every portfolio company likewise, has a set of data that they know cold about their function and comparable companies. But I think very few firms collect this data systematically, and use it in a way that can be leveraged fully. Even just normalizing data across a firms’ portfolio over time, and then using that as a lens through which to look at new investment decisions and follow-ons seems totally rational, yet, few firms do anything like this. And that’s just scratching the surface. Instead, many decisions are driven off the occasional anecdotal datapoint that happens to stick in a partners’ memory.
This kind of analysis doesn’t just help in selection, but ultimately in “win” by helping entrepreneurs know how to prioritize their time and efforts and where they are doing great or falling short.
3. Investment Models. It’s interesting to me that most investment models for VC are not really driven by the characteristics of the market, but work backwards from drivers like fund size, partner capacity, and conventional wisdom. What I also find interesting is that the investment models tend to be pretty similar across different categories of businesses. You still see VCs investing in ~2 deals / year and trying to own ~20%. But different kinds of companies must have very different sorts of risk profiles. On top of that, different VC’s might also just be really good or bad at evaluating certain kinds of opportunities. I often wonder if this should be baked in to an investor’s model explicitly. You could imagine simple rules like “for X kind of company, we will do 2X more deals and live with 1/2 the ownership because we think it’s harder to pick, but the rewards are bigger when you pick right”. It could also be something radically different and systematic like what Correlation Ventures does.
Selection doesn’t stop at the initial investment decision either, but continues in follow-on decisions, both in terms of whether to do a follow-on, and also how much. Again, I think the process of selection here varies by type of company and industry, especially when you think about the different time horizons and inflection points for different sorts of businesses.
4. Decision-making Process Innovations. When we started as a firm, we explicitly decided how we were going to make investment decisions. We tried to draw from the learnings of the firms we all used to work at, both positive and negative. The result is a particular process that we think works, and has been pretty stable over the last couple years. It’s also a process that is pretty different from other firms, although I’d guess many firms have their own nuances and went through a similar process when they started.
It’s easy to have a “blank canvas” approach when you are starting, but much much harder as you are an ongoing team. There is a ton of inertia, preference for the known, and fear of change. But I think it pays to be constantly inventive in thinking through how a partnership views/evaluates deals and makes decisions as a partnership. Even experimenting with different tools, software, internal apps. etc could be pretty helpful.
So that’s some of my current thinking. I think deal sourcing is still the single most important driver to success in VC. But deal selection is way overlooked, and I think there are big opportunities to innovate on this form of VC Product Delivery.
NOTE 1: I DON’T think that a major opportunity here is more onerous due diligence. Actually, I think that doing lots of due diligence is a result of not being systematic enough about what one is looking for or not having a streamlined enough process internally. More diligence doesn’t make VCs perform better. As Rich Levendov has said: “Due diligence is information you studiously gather when you want to kill a deal”
NOTE 2: Thanks to Phin Barnes at FRC who read a draft of this post and helped shape some of my thinking here