Every Investor eventually finds his or her sweet spot in terms of sector, stage and traction and typically does best by sticking to a personal strategy and process for investing. For instance, I’m an early stage Fintech Investor and love backing companies that still have a lot to figure out. It’s where I can be differentially helpful to companies and it’s where the investment strategy and process I’ve honed over the past 11 years seems to work.
But even within my “box”, I’ve noticed a profound change over the past 11 years. The amount of money pouring into many companies that I’m evaluating is at least 2X what it was a decade ago and the valuations are similarly upsized. Because of this, I get asked all the time about whether or not I think the systemic increase in valuations and round sizes for early stage companies is healthy and why they’re happening. Trying to answer this interesting but generic question isn’t simple (nor possible) because there isn’t a single and obvious reason driving the change. But I do have an interesting observation about a class of company and type of Investor that explain some of what’s happening. My observation is pretty counter-intuitive but I think it’s not only real, it’s also having a material impact on how VC Investing works.
The observation: I’ve noticed is that when Team and TAM are both impressive, work stops short for many VC firms and a very aggressive term sheet is lobbed in to win the deal quickly. This isn’t only happening for pre-launch companies. It’s bled into Seed and Series A and even some Series B deals. Team and TAM seem to justify everything.
I’ll come back to why this is a problem, but before I explain more here’s an interesting thought exercise about investing in early stage companies:
Fact 1: Fatal flaws that could torpedo a business are easy to identify because there are a lot of them and they’re everywhere.
Fact 2: For most well thought out businesses, it’s easy to describe a very valuable future version of the business if you’re willing to believe a series of assumptions that if true lead to market dominance.
Fact 3: Outcomes are not equally distributed. Fact 1 situations come true a LOT more than Fact 2 situations. The vast majority of businesses ultimately limp along or fail.
Fact 4: In a classic 2X2 view of the world (Invest Y/N, Great Outcome Y/N) there’s only one quadrant where an investor is happy: The quadrant where you invest in a company and years later it produces a fantastic economic outcome.
Fact 5: Because of Fact 4 you have to overcome your fear of failure if you want to succeed as an investor.
Fact 6: Because LPs only care about the totality of your investment decisions, an early stage investor has to get paid massively when he or she invests in what eventually becomes a great company to more than make up for all the failures along the way.
For the record: I believe in these facts. There’s no disputing them because every analysis of the tens of thousands of early stage Venture backed companies over the past half century lead to these same conclusions.
But while true, I’ve seen members of the VC community use these facts to justify sloppy thinking. And the most common form of sloppy thinking that I encounter regularly sounds something like this:
“Great outcomes only happen when an exceptional team attacks an industry with massive TAM. Exceptional teams typically don’t work on small problems and when they do they expand TAM as they succeed. So in reality all that matters is backing an exceptional team.”
(See how I tied this back to the Team and TAM intro? Clever….)
While this is generally true, as an investor there’s no reason to stop with this logic. Team and TAM are necessary but not sufficient conditions for success. Therefore, decisions based primarily on Team and TAM are more akin to Speculation than they are to Investing!
A Gold Mining Speculator can back a team that’s found gold in the past and give them money to find gold again. The team might need to check out dozens of locations before finding a rich enough source to mine profitably. And there is a significant chance that the team could strike out completely because finding Gold isn’t easy. The Speculator isn’t involved in the mining operations nor are they helping increase the odds of generating a profitable return. They’re trusting the team they’ve backed to do what they do best: Find gold.
In contrast, a former Gold Miner turned Gold Mining Investor can back a team that’s found gold in the past and give them money to find gold again. But before giving the team money to start up their operation, the Investor could advise the team and help shape their plans. They could add knowledge and experience to their capital and hopefully improve the odds of success by challenging the team’s plans and guiding them away from questionable decisions. And, it’s much easier to gate the investment decision based on results as they materialize because the Investor actually knows what he or she is looking at and can put the results in the context of the team’s proposed path forward.
And even though it’s shortsighted, a seasoned team might actually prefer the Speculator’s capital because they believe they know what they’re doing and don’t want outside help. Based on their track record they might have earned the right to make this choice even if it doesn’t maximize the outcome.
But, what if the Gold Miner isn’t experienced? They might have studied Gold Mining or apprenticed with a seasoned Gold Miner in the past, but if they haven’t run a Gold Mining operation themselves they’re going to have to figure out many things in the field. This requires the use of precious capital and time and can lead to disastrous outcomes. What if they throw resources into mining a location that has some gold but not enough to make it economically viable? What if they find gold in a location that has insurmountable logistical challenges to mine profitably? What if they negotiated a multi-year deal for land rights before knowing how much gold can be extracted? All of these things can happen if the CEO of the mining operation has to make quick decisions and doesn’t have an advisor to lean on.
And what if they do succeed? Success comes with its own challenges because it usually requires additional capital and a well thought out plan for how to maximize yield. Operations and processes that work fine at a small scale can easily break when scaled up and it takes a “been there, done that” advisor to help navigate the scaling process.
So while “Team and TAM” are important factors in making investment decisions, I personally believe that a world class investor digs deeper. They have to. And if they can’t (or don’t) then it’s much closer to speculation than it is to investing.
I also believe that there is no such thing as backing a true “serial Gold Miner”. The nature of the businesses we back are that they’re all different and have a different set of challenges. So while there are Serial Entrepreneurs, they can’t rinse and repeat success because each business they attempt to build is different than the last.
To be fair, speculation can lead to massive outcomes but it’s not clear if great outcomes are repeatable with enough frequency to properly price for the risk. And it’s also worth noting that one can “invest” in a company without being an active participant, but not when it’s unclear how their business model will evolve over time and the primary analysis results in the conclusion “they’ll figure it out”.
Which leads me to my last point. If a knowledgeable Investor can improve the odds of success and magnitude of the successful outcomes then this Investor should be willing to pay the highest price. But, the opposite is happening. Speculators have very little to offer outside of their capital and therefore can’t win deals unless they offer the highest price and the fastest process (or are backing Founders who don’t want help).
The Speculators (using their sloppy thinking) justify their valuation, check sizes and “Founder Friendly” provisions on their Team and TAM logic. And God forbid if there’s also some early traction. A little Traction can surface an even worse type of capital provider: A Momentum Speculator! They don’t have to understand the “why” or “what does it take to scale from here” because they point to results and justify their quick trigger term sheets on the basis of “the market is speaking”. What it takes to grow a business to $1MM ARR might be totally different than what it will take to scale it from $1MM ARR to $20MM ARR but this is lost on the Momentum Speculator. They just want to back hot companies.
This forces Founders to make trade offs between working through the process of knowledgeable Investors vs. taking the quick money from Speculators at a valuation that might cause problems down the road. It’s a problem with companies coming out of Accelerators. It’s a problem with businesses being built in “hot” spaces. It’s a problem with Founding teams that are exceptional story tellers. It’s a problem with companies that need to jump on the first term sheet that comes across their desk because of how thinly they’re capitalized. It’s a problem because Founders are being short-term greedy and there’s a lot of generic capital in the hands of Speculators ready to feed their machines.
But a knowledgeable Investor can still win….and should win. Here’s how:
1) Deeply engage a Founder about their business and help refine their business plans during the diligence process. This should make a Founder receptive to a longer and iterative process because you’re making their business better through your engagement. A typical byproduct of this process is that the Founder might conclude that the market is trying to give them more money than they need at that moment. And, through this engagement you’re practicing working with them and them with you which is critically important.
2) Spend time with the company’s current Investors. It will be obvious if your skills and experiences are additive or redundant to the mix. It will also be obvious if you see the business the same way they do or if your advice is going to counter theirs.
3) Build impeccable references. These only come if an Investor delivers on his or her promises to their companies over an extended period of time. References matter because it’s another proof point that what you’re representing in the diligence process maps with reality.
4) Have a rational discussion about the terms of an investment only after becoming the Founder’s top pick. Valuation will matter in the end, but “balanced and fair” should win over “highest price” if you’re the best fit.
The reality is that discipline almost by definition requires saying no to companies when the math behind an Investment decision doesn’t work. Looking back on a “missed rocket ship” isn’t healthy except in the context of trying to figure out how the deal could have been won at a price that reflected the appropriate risk of the company. More effort and engagement during the diligence process? A better personal connection with the Founder? A stronger relationship with the other Investors? A more refined view of what “balanced and fair” terms should have been? Figuring this out has merit and should lead to improving your skills as an Investor.
In full disclosure, Part 2 wasn’t exactly what I meant to write next in the “Ramblings” series, but sometimes I just have to write what’s on my mind (which fits the ramblings theme well). So, hopefully in Part 3 I’ll share what I meant to write in Part 2 and answer some of the hanging questions I posed at the end of Part 1!