I recently wrote a blog post called 8 Myths of the Pre-seed Venture Investing.
In that post, I talked about how different the pre-seed stage is from Series A and later-stage investing. The focus of this post is the opposite: I want to highlight things that are true across stages of investing.
Truth 1. Venture outcomes are driven by a power law
Power law is an immutable law of the universe. Examples include the distribution of population in cities, price of artwork, and of course, and unfortunately, wealth distribution. This law is also known as the Pareto Principle, and colloquially known as the 80%-20% rule.
Venture capital is no exception and the outcomes of every venture portfolio will likely follow a power-law distribution. There are two significant things to think about here.
First, because most startups fail, the distribution is going to have a lot of zeros (or near zeros) in the long tail. The zeros are going to be followed by singles and doubles.
On the other end, the biggest winners, when they happen, tend to be huge. Unicorns were hard to come by when Aileen Lee penned her now-famous article in 2013. Today, unicorns are no longer as rare, and top-tier firms are constructing their portfolio with the goal of funding a Decacorn – a company valued at $10B, or even more.
There is nothing mysterious about the power law dynamic in venture. Just like the rich get richer, the biggest companies get bigger.
A startup that reaches $10M in revenue is much more likely to double, double again, and then cruise by $100M in revenue versus a startup at the $1M mark now trying to get to $10M.
At scale, everything is different – the resources, the possibilities, and access to capital. Of course, even companies that reach a very substantial scale may run into obstacles and eventually underperform. But that is not the point.
The point is that the ones that do end up winning and driving all the returns keep doubling and continue getting bigger and bigger.
Hence, the outcomes of the venture portfolio fit a power law curve.
The best managers in the business are distinguished by a few more at the very top of the curve.
The average manager faces a very real possibility of making no money at all because of how steep the power-law curve is.
Truth 2. Your Fund Size is Your Strategy
There is a piece of feedback that fund of fund managers frequently give to GPs.
Your Fund Size is Your Strategy.
What they are essentially saying is that a fund’s portfolio construction will depend on how much capital under management, and vice versa. Why is that?
Let’s take two extreme examples – a manager of a $10M fund and a manager of a $1B fund. Let’s assume that both managers want to lead rounds. If the first one decided to be a Series A fund, it would be extremely concentrated. It may be able to lead 1-2 rounds, but that’s it. Given the power-law nature of outcomes, it would be extremely unlikely for this manager to generate a good return.
On the other hand, the manager who is managing a $1B fund has a very different problem. She has so much capital to deploy that she doesn’t bother with the super early stage. Investing in pre-seed and early seed companies would rarely make sense as it would take 500 deals at a $2M check size to deploy $1B. Even with 50% reserves, it would be 250 deals. So she can’t do that. Instead, she needs to write large checks, and follow on as much as possible.
Now another math complexity with a larger fund is ownership. To return $1B, the fund needs to own 10% of a company at a $10B level. This is a complex game where the manager needs to really think through her follow-on strategy to make sure she has enough ownership at the finish line.
From these two examples, it is clear that fund size and fund strategy are dependent. This is exactly why funds often specialize at a specific stage of investing:
- Less than $50M Fund – usually pre-seed and small seed
- $150-$300M Fund – usually seed and small series A
- $500M Fund – usually series A
- $1B – usually stage agnostic, but typically no earlier than A, and more likely B+
It’s worth noting that lately, we have seen a trend of late-stage, mega-funds trying to get into companies as early as possible. For many, it’s an option check, with the intention of following on in a big way in future rounds.
Truth 3. Ownership matters
Many smaller pre-seed and seed-stage funds have been learning this very painful lesson: ownership matters.
Let’s start with an example. Say you are running a $20M pre-seed fund and invest $250K into a seed round at a $10M valuation. You own 2.5% of the business. If all goes extremely well and the company becomes a unicorn, how much will you own?
Assuming this very optimistic dilution sequence and unrealistic valuation ramp up:
30% dilution at Series A ($40M valuation)
15% dilution at Series B ($125M valuation)
10% dilution at Series C ($300M valuation)
5% dilution at Series D ($1B valuation)
You will land on 1.27% – less than half of your original ownership. The value of that stake would be $12.7M, which is a lot, but still falls short of returning a $20M fund. The solution here is to either take pro-rata – which small funds can’t really afford or to increase check size and get more ownership upfront.
Let’s look at another example – a $300M fund, buying 20% of the business during a $5M-$7M fundraise (which is now considered a large seed or a small Series A). Assuming the same dilution sequence as above, the fund will own 14.5% at the $1B mark, which is only half of the fund size. The solution here is that the fund needs to follow on and maintain pro-rata, likely through Series C.
Whichever way you look at these equations, you realize three things:
Ownership matters — you need to be disciplined, and you need to get lucky.
The other realization that many managers have is that buying very little in hot deals doesn’t always work, but could work if this is the core strategy, and you get into a lot of hot deals. That is, if you can’t buy enough ownership in any one deal, you should try to get into as many of the absolute “best” deals as possible.
This strategy worked great for Ron Conway at SV Angel, who was known to be the first call in Silicon Valley. Such strategy takes a while to execute — you need to be in venture for a long time and build up a reputation.
Today, it is increasingly more difficult to run such a strategy because of the abundance of capital in the ecosystem. So, if you can’t get into all of the absolute best deals with a smaller check, you need to instead think really hard about ownership.
Truth 4. Venture Business is Hard to Learn
There is a saying that venture is an apprenticeship business.
I dislike this saying because I think it is misleading. Of course, like in every business, having a great mentor or a great manager helps.
What the saying really means is that it takes a while to learn the craft of venture. Why is that? Well like anything else, you can only learn venture by doing — actually investing. The problem is that this is an expensive form of learning.
Consider a $300M fund that is focused on leading $5M-$10M rounds. A firm like this would do 5-7 deals a year and build a portfolio of 25-30 deals and have ~50% in reserves.
If you are a new investor joining this firm, let’s say as an Associate or a Principal, you are unlikely to get any deals done in the first 9-18 months. Instead, you would focus on supporting a Partner. In general, in firms like this, Partners will have to make a final decision on all deals, because they are the ones who are ultimately accountable to LPs.
So how does a junior investment professional learn if she can’t make investments? It is like being in the passenger seat in the car, you kind of never know where you are going.
Ultimately, it takes years before a junior investor can make a few investments, and even those aren’t fully hers.
The alternative routes to learn venture faster are to become an angel investor, to be a founder with a big exit, or to go to a smaller, pre-seed stage fund.
If you can afford to, a great way to start getting into venture is through angel investing. However, this could be expensive and you will learn by making mistakes on your own dime, but if you commit to it for a few years, you will have a natural leg up.
Being a successful founder with a big exit instantly puts you into the VC orbit as a potential partner. Why is that? Two things: first, your experience as a successful operator is attractive to the firm, and will be very valuable to the founders you back.
Secondly, and more importantly, you will have money, and that really matters in venture. To be a General Partner, usually you need to commit your own capital to the fund, especially if it is a large fund. The expected commitment could be $1M+.
Incidentally, this is why it is so hard and could take 5-10 years to go from an Associate to a General Partner in many firms — you need to be able to afford it, and most people can’t.
The final, and I think the best way, to learn venture is to join a small, pre-seed, or seed-stage fund that writes a lot of checks. I was very lucky to spend 5 years running Techstars in NYC where I invested in 100 startups. With this kind of volume, you can see a 360 degree of the world of venture and learn quickly.
Truth 5. Venture Firms are Hard to Scale
To continue on people issues in venture: venture funds are notoriously difficult to scale.
To deploy more capital, the firm ultimately needs to have more Partners. Adding Partners is tricky:
How do you know they will be any good at investing?
How do you know they can raise capital?
How do you know you can trust them?
How do you know you will enjoy working together?
How much of the pie do you share with them?
If a new Partner doesn’t have a track record, how do you know they would be any good at the venture game? You don’t, and the chances are they won’t be, at least not right away, because they haven’t practiced it yet.
As a result, you can’t make them an equal partner or give them meaningful carry upside.
If a new Partner does have a good track record, she instantly wants more upside. That’s fair because she has proof that she is good at it. The issues are then different – trust, getting along, and raising capital from LPs.
Venture Capital is no different from any other business — it takes time to build trust and a good working relationship.
An interview process, as good as it is, can’t guarantee that you will get along. Because of this, venture firms deploy several strategies to mitigate the risk of bringing a new Partner onboard:
Hire a Principal with a clear path to a Partner
Hire a Venture Partner
Hire someone you worked with before on boards
Principals and Venture Partners are effectively “try before you buy.” The difference is that Principals are typically more junior and Venture Partners are a bit more experienced. In both cases, they will be evaluated based on their performance and the quality of the companies they back.
Hiring someone from another firm is another way you can de-risk bringing a new Partner on board. The idea is that you hire someone who you’ve seen in action – typically someone you have worked on boards. You then can better understand their style, thought process, interactions with founders, workability, and of course, investments.
Even with all of this in place, there are challenges – trust, style, and the ability to raise capital from LPs.
It turns out that it is really hard to align around investments. Different Partners like different things, very similar to how different people like different food or clothing.
The deals you like are based on your background, mental models, and the deals you’ve done to date. The deals I like, similarly, are based on the same things, but for me. So we may not align.
For a later-stage firm, you need an alignment because of how much capital you are deploying. Most firms require unanimous decisions to invest, but this is hard. In these firms, you really need to align around a common thesis and methodology for investing.
In smaller firms, trust becomes critical. Each investing Partner can get a deal through, but other Partners need to trust her and be certain she is making good decisions. Again, this takes time and often creates complex relationship dynamics.
People rarely like the same thing, and that is both a blessing and curse in venture. It is a blessing because ultimately, diversified portfolios win; it is a curse because Partners can get angry at each other for doing deals they don’t personally like.
That general anger towards a co-worker is, again, not venture specific. In any job, you may be unhappy because of the people you are working with. You may not like their style, and how they behave or compete with you. In venture, it gets further amplified because the decisions people make are around investments, which are directly tied to money which is finite.
As an engineer, you maybe angry with your product manager for making bad product decisions, but that rarely costs you actual money — it’s not a zero sum game. The venture business is incredibly unforgiving this way — that is, mistakes literally cost money. You lose money when you make mistakes.
As a result, some partnerships have a very challenging dynamic: they keep score, hate on each other, and ultimately fall apart.
Finally, as if there is not enough complexity already, the ability to raise capital factors into the partnership dynamic. In some firms, seasoned Partners have a lot more upside because they bring the capital to the table. This creates another vector of complexity, as it is difficult for more junior Partners to ever catch up.
The only way any of this works if the firm is focused on growing junior people and promoting internally. Otherwise, after several years, a junior person is likely to feel like they are doing all the work, but senior Partners are making all the money. When that happens, junior people leave.
Because of all of these dynamics, it is really difficult to grow a venture firm. The ones that succeed are incredibly thoughtful and deliberate about how they do it.
Truth 6. You are as good as your deal flow
There was a recent thread on Twitter that debated what is more important: deal flow or picking.
I think the answer is very simple – both are critical, but if you have a crappy deal flow, you have nothing to pick from. To put it differently:
You cannot invest in the the deals you don’t see.
At the earliest stage, deal flow is a volume game, and at a later stage, it is a quality and research game.
Let’s start with the later stage: if you map out the spaces you are interested in, you need to cultivate deal flow through proactive research and thought leadership.
This is what all best firms do: they develop theses, market maps, and roadmaps, and then deploy analysts to gather information and get in front of all of the best companies ahead of their raises. Having a strong network is less important when you are running this strategy. You do, of course, need to have a strong reputation, but you aren’t fully relying on your network for all your deal flow.
The game at the early stage is very different. It is hard to develop this kind of sourcing model because of the sheer volume of companies, and the absence of a complete catalog of early-stage startups.
Early stage sourcing is a volume game, and a game of building a strong network.
You need to see as many deals as possible, and ideally, high-quality deals, to find the true gems. Your network is absolutely critical — even when you have a great firm brand, you will still lean on your network to get deals, increase volume, and shortcut/filter to the best ones during diligence.
Truth 7. Time management is everything
And the last thing: venture capital requires exceptional discipline, especially around time management.
Very few people appreciate just how difficult this job is. The reason is that you have at least 4 jobs in one job:
Building your firm
Raising money and managing LPs
Finding amazing founders and winning deals
Working with your portfolio post-investment
The longer you are in venture, the bigger your portfolio is, and the smarter you need to be about self-care and calendaring. If you are disorganized, you are going to struggle, be unhappy, and are unlikely to win.
At the extreme, we’ve all seen this really rude behavior where a senior Partner walks into a meeting with a founder, and within five minutes realizes he won’t invest in her and excuses himself out. This is, without a doubt, a shame for our industry. The underlying cause, but certainly not an excuse, is the scarcity of time.
To be successful and happy in venture, you have to really love it. You can’t be in the business just to make money. That will just drive you crazy.
If you love what you do, and are self-aware, you will figure out how to do this amazing and incredibly rewarding job.
Being a VC is a privilege, but it is certainly not an easy job.