AGILEVC My idle thoughts on tech startups

February 9, 2012

The VC industry is a competitive business.  So are most disciplines within the investing world, but the fundamental framework and manner in which we compete in VC is pretty different.

In the modern age public market investors, whether they be focused on equities (stocks), fixed income (bonds), currencies, commodities, or derivatives of these, all have access to essentially the same investment choices and the same body of information.  Even new innovations, like advanced trading systems and low-latency infrastructure deployed by high frequency traders, get diffused and democratized pretty quickly eliminating the arbitrage in the long run.  So ultimately whatever alpha exists must be generated by analysis, foresight, and clear thinking.

Even other forms of private investing (growth equity, buyouts, real estate, distressed, etc) have a pretty different competitive framework.  There are more similarities with early-stage VC than public investing, but in these asset classes you still see somewhat more uniform access to investment opportunities and less information asymmetry.  That’s because intermediaries like bankers/brokers, and even internal cold-call sourcing operations, create more standardized access to and information about potential deals.  Also these are typically more mature assets that can be analyzed and understood in broader ways than a de novo startup.

Success in early-stage VC ultimately comes down to investors’ ability to source, select, and win the best investment opportunities.

Sourcing is critical because each VC firm’s investment opportunity set is inherently unique.  Every mutual fund in the world can buy stock in any publicly traded company, but even the most respected VCs don’t see all of the “best” opportunities.  A lot of times you hear VCs talk about their sourcing in raw numbers… “we saw X opportunities in 2011 and invested in [small fraction of X]“.  But ultimately “good” dealflow is about signals – large amplitude, high signal to noise ratio, and enough strong signals on an absolute basis to build a portfolio.  You’d rather have a lot of high quality dealflow that’s relevant to your strategy (stage, sector, geography, etc) than simply winning the “we got the most business plans” award.

To illustrate what great sourcing means, let me give an analogy from the academic world.  Harvard gets more applications than pretty much any undergraduate program in the US, and they accept a small fraction (7.2%) of those folks.  Harvey Mudd on the other hand gets far fewer applicants (Harvard gets >10x more) and is less “selective” in the sense that they admit about 25% of the students that apply.  Yet Harvey Mudd’s students are incredible, and the school produces the best paid graduates of any undergrad program in the country.  College is obviously about more than just landing a well-paid job, and I’m not saying Harvey Mudd is inherently better than Harvard… they’re both great.  But sourcing the best VC deals or college applicants isn’t merely a numbers exercise.

It turns out selecting is arguably the least important of the three.  Returns in venture are driven primarily by outlier outcomes, so being a great stock-picker or paying the lowest valuations does you little good if you’re selecting from a pool of mediocre opportunities or if you’re consistently unable to win great opportunities.  As Peter Thiel used to say, there is no subprime model for VC.  I’m not saying selecting doesn’t matter… Facebook’s investors and MySpace’s investors each did well, but we all know one group did a little “more” well.  So being good at selecting is as much about having an effective process as a firm for making decisions and a well-functioning partnership to do it.

Finally, even if you source and select great opportunities you usually have to win the right to invest against other good investors.  At the end of the day, all VCs are selling expensive equity capital and despite the ongoing contraction in the industry there’s still a lot of capital out there.  How do you win?  It obviously depends who you’re competing against… at the seed stage where NextView plays, there’s a range of different types of investors (large lifecycle VC funds, seed/micro VC funds, angels, etc) so sometimes it’s an apples vs oranges choice by the entrepreneur.  Brand, both firm brand and individual partner brand, clearly matters.  Ultimately though like any selling process, enthusiastic and respected reference customers (e.g. other entrepreneurs you’ve backed) are usually the best tool for the job.

You’ll notice I didn’t include “add value post investment” in the source, select, win factors of success.  This is clearly important and something I think the best venture investors do well.   Also because the VC business is a multi-turn game, in the long run being a helpful investor in the eyes of entrepreneurs directly increases a VCs ability to source and win opportunities.  But ultimately I don’t believe it’s the key determinant of success in the same way as the others.

Source, select, win.  We think about it every day at NextView, and are continuously refining how we can get better at each of them.