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.

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!

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.

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.

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?

A few weeks ago, I wrote about an example of an emerging VC fund manager’s success creating a problem because his fund size increased. I’ve heard this multiple times from both emerging fund managers who’ve raised larger funds and established fund managers who started with small-fund investing at the earliest stages. I recently had a chat with someone from a family office that’s a limited partner in venture capital funds (i.e., it invests in them).

He shared a few interesting things. The first is that they want to invest in great companies as early as possible (i.e., a few hundred thousand dollars at the pre-seed level). They don’t have the ability to source them internally, so they try to find fund managers who focus on this segment and invest in their funds. They believe that emerging managers with micro funds perform best at the pre-seed stage (more on this in another post). Finding and evaluating these emerging managers is difficult. It can be just as hard to find a promising emerging fund manager as it is to find a promising early-stage founder (they’re both early-stage founders in my mind), and this family office isn’t staffed to do that kind of outbound sourcing.

The second challenge was around stage creep. If they find an emerging manager to invest in whose pre-seed investments perform well, that manager usually raises a larger fund. The larger fund likely causes the manager to start investing at a later stage than the family office’s target (e.g., a few million dollars at seed+ instead of pre-seed). And this causes another problem: the family office has deployed capital with another manager at the later stage (that is, it already has a seed+ fund manager), so it now has overlap.

The family office now must start the cycle all over again. It needs to find another emerging manager who focuses on pre-seed or go with an established manager focused on pre-seed-stage investing whose larger fund will negatively affect returns.

There are lots of variables and things to consider that I didn’t get into to keep this simple, but that’s the gist of our conversation.

Of course, all family offices aren’t created equal, and family offices aren’t the only type of limited partner. Different classes of limited partners have different risk appetites for pre-seed investments, and even within those classes, each organization is motivated by different things. This is an anecdotal story, but one I've heard from more than one family office.

It’s interesting that there’s a desire for certain types of limited partners and emerging managers for investment at the earliest stages of a company’s life cycle, but the current VC construct isn’t working efficiently for emerging managers, limited partners, or start-up founders.

Yesterday I shared a few takeaways from reading The Power Law: Venture Capital and the Making of the New Future. The book does a great job of describing some early-stage venture capital investments that had outsize returns (Cisco, Apple, Google, eBay, Alibaba, Facebook, Uber, etc.). There’s a story behind each of these deals, and the book tells each story in an interesting way and even gives specific financial details on some of these investments.

These deals were all different, but they had one thing in common: the companies were early into new markets that quickly became massive. Most ended up dominating their markets (for better or worse).

Markets matter a lot. They have a material impact on outcomes. Founders should be aware of this and be honest with themselves about the market they’re going after. If you’re solving a problem in a slow-growth or declining market, an already difficult journey will likely be many times harder.

I’ve talked to many emerging and established venture capital investors over the last few months. They confirmed that starting a venture capital fund is very much an entrepreneurial endeavor. When funds are first getting off the ground, these partners are no different than any other founder. I’ve heard consistently that there’s no playbook for starting a venture capital firm.

I’ve dug into this, and I haven’t found a playbook. A few programs offer to help emerging fund managers with specific challenges. That’s not a playbook. Many emerging fund managers are relying on word-of-mouth information and figuring things out as they go. Some have the benefit of being coached by seasoned fund managers who help guide them along their journey. But that’s the exception.

I’m not convinced that the world needs more venture capital investors, but this got me thinking. What impact would a playbook have if it were put in the hands of people with a unique perspective who’ve identified high-potential founders or early markets outside the purview of venture capital networks and start-up ecosystems? How would that change the impact entrepreneurship could have on society?

Harj Taggar discussed why being a partner at Y Combinator (YC) is so powerful for an investor. He’s done two stints as a partner at YC, so I was curious to hear his thoughts. During his interview, he shared that working with hundreds of companies a year allows a YC partner to learn more, faster, than a traditional venture capitalist can. Learning what works and doesn’t work is accelerated, and YC partners feed those learnings back into the companies—all with a goal of reducing the overall failure rate over time.

Harj’s interview made me think of what a good friend said: the faster you learn, the more successful you become. Harj’s thoughts on YC being a place of accelerated learning, which leads to more success, make a lot of sense. It’s a feedback loop of sorts. The learning is compounding with each YC cohort of founders.

This has me thinking . . . what are other ways are there to create feedback loops for outlier entrepreneurs—those outside the purview of venture capital networks and start-up ecosystems?

Today I was looking at a few tech companies in the public stock market. The market capitalizations (i.e., valuation) on some have been drastically reduced. I’d imagine it’s a big distraction to the leadership and employees. I was thinking that some of these companies could benefit from being part of a larger organization where they could execute on their strategy without worrying about market gyrations or scrutiny.

Nonfinancial companies issued $1.7 trillion in bonds in 2020. That was a record. Partly it was due to the uncertainty at the time, but it was also driven by interest rates reaching record lows. It was cheap to borrow, so companies borrowed.

Many great companies are valued at a fraction of what they were, yet the fundamentals of the underlying business remain solid. I’m sure this fact hasn’t gone unnoticed by the leaders and M&A teams at companies flush with cash. If valuations keep going down, I suspect we’ll see some of these companies putting that cash to work in acquisitions.