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Along with the reasons I’ve previously discussed, this list and chart below clearly suggest that becoming a venture investor (or more specifically a seed stage VC) is easier than it’s ever been. Yes, fundraising is hard, but with patience and pragmatism, the barriers of entry are low for new entrants.
While entering VC is one thing, having staying power is another, and the challenge of building and maintaining a durable venture franchise continues to increase.
It’s why I often ask aspiring venture managers the blunt question — “Why do you exist”?
I ask this question because I want to understand why they are starting a firm, and more importantly, why they believe their firm will stand the test of time in such a crowded field. It’s an inquiry that is often met with generic marketing speak and misplaced moxie, but it’s a question that all prospective venture managers should brutal confront prior to taking third party capital.
Starting a venture firm isn’t just about raising a fund and investing in new companies — it’s a commitment to your constituents (LP’s, entrepreneurs, employees) to be a great long term steward of the business. Outside of a few exceptions, I’d strongly discourage managers that are not 100% ready to commit the next 20 years of their careers to building their proposed franchise from raising a fund until they are sure.
For managers that are committed to building a venture firm capable of consistent alpha returns, what is needed? Many LP’s would answer that it comes down to the manager being substantially “differentiated” from their peer group.
The reality is that almost all successful fund managers possess a degree ofauthentic differentiation, a trait or set of traits that clearly points to a meaningful and comparative advantage relative to the competition. Because venture is an asset class with skewed returns requiring both skill and luck, authentic differentiation is the fundamental basis that increases a firm’s probability of producing consistent outsized returns.
Authentic differentiation can be measured in many ways, but I want to focus the scope of this article on how it translates to the three core building blocks of venture investing:
Nearly every manager I meet expresses that they have great deal flow as it relates to companies that fall within their investment thesis. Many managers overrate their deal flow by anecdotally recalling quality deals or viewing deal flow strength through the lens of deal velocity. Possessing a competitive sourcing advantage relative to others requires consistent access to highly curated pools of top founder talent.
From my experience, firms with authentic sourcing advantages are intensely formulaic in building a sourcing moat through the development of extreme network centrality, branding, and the sense of differentiated domain expertise.
Below are just a few examples of firms that appear to have distinctcomparative advantages around sourcing:
Forerunner — Reputation as the go-to firm for commerce startups
SaaStr –GP with a deep background in SaaS, who also runs a wildy successful conference.
Homebrew — GP’s with great reputations amongst founders, and with very strong social brands within the entrepreneurial community.
Haystack — GP that’s become a key node in the venture ecosystem.
Differentiating on the basis of being a better company picker than other seed investors is a nearly impossible task for managers starting new firms. While it’s true that prior track records are often what LP’s use to separate wheat from chaff, it doesn’t necessarily indicate any advantage around picking (and note than track records are often heavily discounted as questions around transferability, accuracy, and luck can be considered). The practice of seed investing involves having little to no visibility into the business fundamentals and viability of prospective investments. And in many cases, business models aren’t defined until post-investment. This was certainly the case for companies like Lyft (originally Zimride), Twitter (Odeo), Uber (simply a black car service), and Instagram (originally Burbn). For managers seeking to determine whether they have a true advantage when it comes to picking, truthfully answering the following questions can provide an answer:
- Does the manager have a strong and correlated track record that has sufficient duration (at least 7–10 years) to support top-decile pattern recognition skills?
- When a manager’s track record is examined, were the winners largely a function of echo chamber investing? It’s very easy to automatically correlate a strong track record with being a good company picker. However, the top venture investors historically have been those that are not only able to think independently but make non-consensus bets when high conviction is present(I really don’t like the term contrarian investing as being a contrarian investor doesn’t necessarily mean being a good investor).
If the answer to both of the questions above isn’t an unequivocal yes, it’s unlikely that manager has a picking advantage over others.
Consistently winning the “best” deals without having to pay above market terms comes down to tangibly answering the question of “why are the best founders/companies going to take money from my firm over other firms when options are present”?
As a venture capitalist, it’s important to understand that you are in the service provider business. The best entrepreneurs generally have the luxury of picking who goes on their cap tables. Usually, it’s a combination of personality(likability and ability to engender relationship and trust) and the confidence that there will be some REAL value-add brought to the table. Every venture manager will express that they add value, but the ones that do areprescriptive about value-add and have a defined structure/process/modelthat clearly delivers a needed service that their clients (entrepreneurs) not easily found with other firms.
I encourage all prospective VC managers to honestly assess their capabilities and ask themselves — how are we authentically differentiated on sourcing, picking and winning deals? Authentic differentiation means more than being adequate or good, but having a real competitive advantage to your peer group.
If you can persuasively demonstrate your advantage on at least 2 of these aspects, then starting a venture firm seems reasonable (have 3? You’re golden). If you have less than 2, it’s time to go back to the drawing board for something more concrete.