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It’s clear through the first half of 2018 that the pace of new Micro-VC firm formations hasn’t slowed (and in fact appears slightly ahead of 2017’s record pace). Understandably, sophisticated LPs that allocate to emerging managers are laser focused on finding managers that can demonstrate meaningful differentiation prior to committing.
Most new venture managers appreciate that some competitive edge is needed, but often miss on what it means to be meaningfully differentiated.
Since selling LPs solely on the premise of being a better picker of companies is next to impossible, it’s best for managers to focus on strategies that demonstrate clear advantages when it comes to sourcing, winning, and post-investment activity. As an aside, I think it takes ~10 years of consistent performance before a case can be made that someone is a good picker and advisor of companies (luck and limited sample sizes make measurement of skill impossible in the early years).
With that backdrop, let’s examine the key components necessary for a meaningfully differentiated model. All of these should be present within a firm that exhibits true differentiation.
It’s tangible and durable
Fledging firms should have some type of “moat” that gives them some degree of an advantage versus peers that play within a similar investment thesis. This moat should be very difficult for others to replicate, and be very clear for founders to understand. This moat could be simple as superior domain expertise or network, but needs to be extremely specific in nature (i.e. “rolling up my sleeves and hustling” or having an “awesome network” with no specificity are not examples of moats).
Additionally, any moat should reasonably stand the test of time. As a result, a core primary differentiator for a firm can’t be simply be running a geographically or stage focused firm. In these cases, market forces tend to ultimately converge and create atrophy in any advantages that might have been initially present.
When I review strategies with managers, I generally look for an “operating methodology” that demonstrates some sort of definitive framework on how the firm invests, picks, and adds value to portfolio companies. Having this type of framework allows for a few things:
1/ It allows for consistency of approach, a key driver of repeatable performance across funds.
2/ Creating a framework enables performance measurement around processes, which is particularly important as the feedback loop for relevant investment performance is incredibly and painfully protracted.
3/ It provides clarity and transparency for founders and LP’s into your culture, value add, and method of conducting business.
Creating something systematized doesn’t need to be overly complex, but needs to be something that is repeatable, measurable, and clear.
It must be authentic to the team/individual
While seemingly intuitive, it’s not uncommon for LPs to see managers that are pursuing strategies based on where they believe opportunities to lie without regard how their strengths and experience align with such strategies. This type of situation provides the impression of manufactured differentiation for the sake of fundraising.
Differentiation that is misaligned with your investor “superpower” is almost assuredly a failing strategy. As a manager, it’s best to utilize a bottom’s up approach to determine differentiation by first taking honest inventory of your experiences, values, and perspectives, and then building a strategy that aligns around those areas.
It truly matters to founders
Not dissimilar to companies that must evidence product-market fit to customers, managers should also have a unique model that founders (their customers) truly care about. Firms that have differentiation in areas critically important to founders typically enjoy extreme advantages when it comes to sourcing and winning deals. From an LP standpoint, feeling comfortable that a firm has a clearly differentiated edge with founders goes a long way into assessing investment suitability.
There are a myriad of other factors that go into running a successful franchise of course, but having differentiation that meets the criteria listed above should undeniably provide managers with a better probability of outsized returns.