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Try Fishing Out of a Different Pond

I spent time today talking with a friend and fellow investor. We talked about similarities in various venture capital firms. Many firms are fishing in the same pond, we agreed—they recruit people from the same network and use similar strategies to source and evaluate founders. He said something that resonated with me:

“If everybody follows the same playbook, the returns will reflect this.”

My buddy makes a great point. If a venture firm is making investments similar to those of other firms and generally doing what other firms do, that’s consensus investing. They’re likely investing in consensus founders solving obvious problems. That’s a recipe not for outsize returns but for average or below-average returns.

This truth was masked by the rising market over the last few years since a rising tide lifts all boats. The tide seems to be going out now, and I’m curious to see what changes early-stage firms make to their playbooks.

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The Best Founders and Investments Don’t Fit into Convenient Buckets

I listened to Michael Moritz share his thoughts on venture capital investing. Michael is a former journalist turned venture capitalist at Sequoia Capital (he joined in 1986). He isn’t just an investment partner—he’s been part of the firm’s leadership team for decades. He played an integral role in the firm’s international expansion and expansion into investing beyond venture capital stages. Given his unusual path to venture capital and the firm’s success, I was curious to hear what he had to say.

One of Michael’s insights that jumped out to me was his perspective on classifying founders and ideas:

To me, the best investments are the ones that don’t fit into a convenient bucket.

He cited Airbnb, Yahoo, Uber, and others as examples. The concepts behind those businesses were different than the norm at the time. It’s obvious now that they’ve worked out, but back then, the founders and their niche ideas weren’t obvious winners. Michael and others had to intentionally look past that.

I like Michael’s perspective. Sequoia’s investments in non-consensus ideas and people led to outsize results. Even though those founders and ideas didn’t fit into logical buckets at the time, investors still made the leap of faith to partner with them. This wasn’t just one or two lucky investments. Sequoia has a history of doing this, which implies that it’s core to their strategy and contributes to their success.

It makes sense that nonobvious people, ideas, and problems won’t fit into buckets. If they did, they’d be obvious.

I think other VC investors can learn a lot from Sequoia. The best people and problems can seem odd. But if you look past the surface, ignore the consensus feedback, and take the leap of faith, you could find yourself with a series of outsize returns and lifelong partnerships with founders who change the world.

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A Deeply Personal Investment Thesis

I listened to an investor share his investment thesis and why he chose it. For a surprising reason, he invests in clean tech. He grew up near contaminated soil that affected him and others in his hometown. Because of this exposure, he’s been getting treatment (including multiple surgeries) for a failing organ for years. The organ is vital—if it fails, he could die. Because of his personal experience and that of others in his hometown, he’s been passionate about clean tech investing for several years.

This investor isn’t focused just on returns. He wants to make sure others don’t have to endure the suffering he has. That passion is what drives him, and he puts that same passion into helping the founders he invests in.

If you’re a founder seeking capital, consider asking potential investors why they chose their investment thesis. If their story is as compelling as this investor’s, you’ve likely found a good partner.

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Limited Partners’ Early-Stage Investing Dilemma

VC funds can have a big influence on start-ups. VC funds get the capital to invest in companies from their limited partners (LPs). LPs can be individuals, families, or organizations (pensions, endowments, corporations, etc.). I connected with someone who knows the LP world well and helps LPs discover and evaluate VC fund managers. One of his points, which is accurate, is that when LPs find a VC fund manager to invest in, they want to back multiple funds managed by that person (i.e., invest for many years). He also said many LPs want to back VC managers who invest early in emerging technologies and markets. Said differently, they want to invest in a VC fund that can help them invest early and for many years in innovative companies.

Early VC investing is done at a nascent time in a company’s life cycle. Founders haven’t found product–market fit (if they’ve even built a product). It’s not surprising for founders to have a problem they’re passionate about and just an idea about how to solve it. This stage is commonly referred to as the pre-seed or seed stage.

Pre-seed and seed stage investing is different than later stages (when product–market fit has been achieved) in various ways. It’s more transient and in a constant state of flux. Let’s dive deeper into this:

  • Flux – The rate of change in the world is accelerating. People are constantly discovering new problems, creating new technologies, and thinking of new ways to repurpose existing technologies. And they’re doing this at a faster rate. Some things end up being viable to form a company around, and some don’t. Keeping a finger on the pulse of all this flux and identifying the promising people and problems isn’t easy. It requires constant refreshing of your perspective and relationships, among other things.
  • Transient – Companies either succeed or fail, so companies are constantly transitioning into and out of this very early stage. VC fund managers investing at this stage (likely emerging managers) are similar. The managers that fail stop investing. The successful ones raise a larger fund, which usually pushes them to start investing at a later stage ( more on that here and here). When this happens, it can cause misalignment between LPs and VC fund managers (more on that here) and cause VC fund managers to transition out of investing at this stage too.

Some LPs want to invest in cutting-edge companies early and they want to back a VC fund manager who can do this for them for many years. This approach works at later stages (Series A and later), but given the flux and transience at the pre-seed or seed stage, it doesn’t make sense then. These two goals are counter to one another when investing this early. I believe some LPs want to invest in innovative companies as early as possible because of the potential financial upside and societal impact. But backing the same VC fund manager for many years isn’t the right action to support that goal. It would likely have the opposite effect. I suspect LPs want relationship consistency (or something else) for various reasons and think backing the same manager is the answer. They may believe this because it’s all that’s been available to them historically (other than sourcing founders themselves).

There’s a disconnect here. The stated goal and the action being taken to accomplish that goal aren’t aligned, and I’m not sure people realize that. I suspect this is affecting the efficiency of capital and resource deployment to early-stage founders. There’s likely an opportunity to present an alternative solution that embraces the transient and flux nature of this early stage but also addresses LPs’ other concerns (e.g., relationship consistency).

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The Top-Ranked VC Firm Is . . .

I read about a new ranking system for VC firms created by two college students. Founder’s Choice VC Leaderboard crowdsources rankings of VC firms. The platform allows founders to rank the VC firms that invested in their start-up. It verifies the founders’ identities via LinkedIn and fact-checks the investments in the company via CrunchBase. The process isn’t perfect, but it does provide insight from a founder’s perspective.

The top-ranked firm is Union Square Ventures in New York. I’ve read the founding partner’s blog for years, and I’m not surprised his firm is ranked highest. The top ten included Atlanta-based TTV Capital, which was a great win for the city. Most surprisingly, the most notable firms weren’t in the top ten. Sequoia is often regarded as one of the best firms with the most consistent track record, but it ranked number eleven. Again, this ranking approach isn’t without flaws, but it’s interesting, nonetheless.

Venture capital firms serve two main stakeholders: the limited partners who trust them with capital to invest and the founders to whom they deploy the capital. I’m glad there’s another platform on which founders can share their perspectives about the VC firms they’ve worked with.

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Why Early-Stage Investing Is Interesting

A long-time friend asked why I’m so intrigued by early-stage founders and investing. He’s surprised that I don’t like later-stage investing more because there are more measurable data points. I enjoy helping founders at any stage, but I do like the early stage the most. I define “early stage” as pre–product/market fit, so it includes the pre-seed or even seed stage. Here are a few reasons I like this stage:

  • Empathy – I started my own company, so I empathize with the zero-to-one segment of the journey. I don’t think you can fully understand it unless you’ve lived it.
  • Turnover – The more I’ve zoomed out, the more I realize that early-stage investing is often transient. Founders moving to the next stage is expected and a great thing. I don’t think people realize that many VC investors move to later-stage investing if they’re successful and raise a larger fund. As the VC investors transition, so do the limited partners that invested in their funds. Given all of this, turnover at the earliest stage of investing is high for all stakeholders. I enjoy helping others navigate this transient environment.
  • Impact – Helping founders at this stage can have a massive impact. The right piece of advice or the right introduction can change someone’s trajectory.
  • Challenge – It’s a difficult stage to invest in. Many people shy away from pre-seed investing because of its challenges and the high failure rate. I view these as problems that can be solved for.

I don’t think the current VC construct for early-stage investing efficiently deploys capital outside traditional VC networks. It can be improved. I want to be part of that solution.

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No One Else Is Looking at This. Is It a Unique Insight?

I’ve been looking for data to quantify how the network problem in VC affects fund returns and efficiency of capital allocation to early-stage founders. I suspect that VCs that subscribe to the usual approach have funds that perform worse than those with diverse networks closer to ground level (i.e., network entrepreneurs are already in). I’ve read several academic papers that dive into VC networks, but they’ve all looked at this from the perspective of existing VC networks. Said differently, the papers look at how well VCs network among themselves and how that affects fund performance.

My observation seems obvious, but it’s been challenging to find research or data on this point—either way. I’m starting to wonder why people haven’t spent more time looking at things from this perspective. Maybe it isn’t as obvious as it feels to me. I connected with one other person researching VC from this perspective, and he shared that he too feels like no one else is looking at things from this angle. There seems to be a miniscule contingent that is. Others accept the status quo in VC. This makes me wonder if this a unique insight that could be the foundation of a game-changing solution.

I’m not sure right now, but I’ll be keeping this top of mind as I progress. I’ll be excited if this is a unique insight!

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No Right Way in VC

I chatted with a venture investor today. He built a new approach to deploying early-stage capital to early founders. It’s doing well and could prove impactful. I asked what he’d learned from watching this new approach to investing take off. He said he learned that there is no right way in venture capital—there’s only the way that’s available to you.

He shared a ton of other great things that I’ll digest shortly, but this one immediately stuck out to me because I don’t think it’s historically been true of the venture capital industry. The network problem in VC applied to outsiders looking to enter the industry as investors and, of course, founders seeking capital. No way was available to people outside traditional venture capital networks.

The pandemic and other factors have changed venture capital. I think we’ll begin to see new ways for high-potential venture investors to raise and deploy capital and for high-potential founders to connect with investors and access capital. When that happens, the entrepreneurial impact will be massive.

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How One VC Fund Addressed Cash Flow

Yesterday I shared a post on how cash flow likely influences fund managers’ decisions to increase their fund size. I ended with a question: Would emerging managers keep their funds small if cash flow wasn’t directly tied to fund size?

Today I had a chat with someone who has an operator and early-stage investing background. He shared his experience as an investor and the model his group used to avoid increasing fund size. They charged a standard 20% carry. And instead of a management fee that was a percentage of capital raised, they charged a flat fee to each limited partner. These fees helped cover operating expenses and allowed them to keep the fund size optimal for the investing stage they were targeting. Their model had other interesting nuances, but this was their basic approach to addressing the cash flow issue.

This approach has pros and cons . . . but they’ve been around for almost 20 years. Definitely something to learn more about and consider.

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Why Don’t VC Fund Managers Keep Funds Small?

A friend read my posts about larger VC funds creating hurdles (here and here) and asked a great question. Why don’t emerging fund managers keep their funds small? I didn’t address this in my posts, so I’ll touch on it today.

Fund managers are usually compensated in two ways:

  • Management fees – The percentage of the capital raised that's used to run the fund. For example, if you raise a $10 million fund with a 2% management fee, you have $200,000 annually for salaries, rent, etc. Specifics around management fees (i.e., duration) can vary by fund. But this is how fund managers keep the lights on and give themselves runway (i.e., salary) to find and support companies.
  • Carried interest (carry) – The share of profits paid to the fund manager as incentive compensation. For example, if a fund realizes a $10 million profit (i.e., money above the original capital investors’ commitment) and has 20% carry, the fund manager would receive $2 million in carry. Carry is unpredictable. It’s usually paid as the fund receives capital from company liquidations over the life of the fund (usually 10 years).

If managers successfully raise a fund, management fees are predictable, while carry isn’t guaranteed and payment of it is unpredictable. I’d imagine most managers opt to increase their fund sizes to increase the predictable cash flow from management fees, even though it could lower fund performance.

I wonder if emerging managers would keep their funds small if cash flow wasn’t directly tied to the size of the fund?

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