In search of things new and useful.
Deal Selection in Venture Capital
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