The skeptic's guide to Venture Capital

Background: I worked in VC for a bit

For about 2 years, I worked for a brand new NYC-based fund. We did seed investments, usually from $250K to $750K, for sizeable percentages of our portfolio companies.

Over two years I got the chance to speak to 300-400 companies, do deep diligence on 20-25, and develop my own approach to founders. It's not an illustrious career, but it's enough time to understand the ecosystem.

How I spent time:

My fund didn't have much of a presence in New York City, so I needed to start out from 0. And that taught me a pretty interesting lesson about networking.

Networking is broken.

Common knowledge early on in a VC career focuses on events: panels, discussions, fireside chats, conferences, you name it. But these are really wasteful.

You rarely meet quality contacts in the audience, so you're after the speakers. But at 2-3 hours per event, getting to speakers can cost you up to 45 minutes per speaker (depending on how many there are).

I found a different method much more effective: just message people! If you write a thoughtful, personalized cold email – or engage effectively on Twitter – then your chances of a quality meeting are much higher than bugging someone after their panel. It's pretty easy to guess email addresses and find handles, and it's way more efficient.

Time to get in contact:

Turns out people respond to messages if you write them with care. I started out by emailing 1-2 people each at the 50 top funds in NYC, and more than 70% responded within a few weeks. Those meetings created relationships as real as any other method of getting your foot in the door.

This is not a brag: it's a knock on the traditional way of meeting people. In an age dominated by digital communication and amazing opportunities for interest-based connection, there's a better way to network. But I think that high response rate was likely also due to another factor: there's way more capital in the ecosystem these days.

The industry is swimming in capital.

With sustained low interest rates (thanks 2008!) and the allure of technology finally making into mainstream culture, there's more money being invested by VC funds nowadays than at any time in history (other than 2000).

VC dollars invested:

Deal sizes, valuations, and counts have more or less been growing accordingly. There seem to be more and more funds popping up without differentiated strategies or technology. Which all begs the question: is there too much money around?

The answer is complicated. Here's what we do know:

VC-backed acquisitions have been declining by meaningful percentages for a few years already
There's been a notable drop in early stage funding recently
Tech startups are not being formed more frequently than in the past, despite the increase in capitalization (I wrote about this on Crunchbase here)

The facts paint a blurry picture. Financial markets – even obscure ones – always function in cycles, and that means time cures most maladies. But capital isn't the only part of the landscape that's changing: funds are finding themselves increasingly impacted by data.

Data is transforming the ecosystem.

Data is becoming more ingrained in pretty much everything, and early stage investing is no exception. It can aid in:

Sourcing better, more relevant companies faster
Automating the diligence process by predicting startup outcomes
Scraping the web to help portfolio companies recruit

The transition, though, hasn't been so smooth. In the early stage community, leaders are still skeptical about using data to invest.

Here's how the debate holds up (click to toggle):

The Case For Data

Data might not be very helpful right now, but the future rarely resembles the past.

Algorithms are improving exponentially in many areas
We'll soon be able to understand people and personality algorithmically
"It's too personal and not scalable" is always the excuse for industries before they get disrupted

The industry is investing heavily in data, and it's only a matter of time until business models shift.

The Middle Ground

Investors can astutely combine their personal expertise with algorithms.

Most of the great Machine Learning solutions out there combine the algorithmic and subjective
Data doesn't need to totally take over, just contribute
We should be prepared whenever strides in VC data get made

The answer doesn't need to be binary. What wins is an openness to new developments combined with a respect for the traditional way of doing things.

The Case Against Data

Early stage investing is too qualitative for predictions to be accurate.

Investing is a people game, and people can't be quantified
Data quality and availability is ABYSMAL and most of the time useless
Everything can't be vectorized: some industries just need to work a certain way

If we see evidence of meaningful progress through data, we'll get on board. Right now it's just not clear that it's going to work.

When I was finishing up school in early 2017, I wrote a paper about how to integrate data into a few different parts of the VC "stack" – and it was not easy to find funds to interview. That's changing quickly:

Social Capital launched Capital-as-a-Service to invest in startups automatically
SignalFire raised a massive $330M second fund to use data for portfolio support
CircleUp has been investing in CPG brands through data
A number of high profile venture funds have been hiring data science teams

As a Data Scientist, I'm biased towards data having a positive impact on the venture community. I'm also biased towards this future because I think venture is a supply game, not a picking one.

Investors don't pick – supply is the advantage.

Most investors see themselves as sifters: a sea of startups lay before them, and it's their job to filter out the best, most successful ones for investment. The best venture funds are supposed to have a natural, innate ability to select. Young Associates need to learn how to "pattern match" to grow their careers.

I think most of this is wishful thinking. The reality remains that when it comes to venture economics, it's an outsized probability game: in a given portfolio, 2 or 3 companies will likely return the vast majority of required capital (although other outcomes may happen, and micro-funds operate slightly differently).

Portfolio Return Structure:

The reality is that most of the companies that a VC "picks" actually fail, at least with respect to fund goals; even if your return structure ends up as more balanced. It's a well kept industry secret that less than 15% of funds will ever return meaningful capital to their LPs. Even the successful ones follow the above power law. Are you sure that these people can really "pick" winners?

Yet, the best funds out there – the Benchmarks and Sequoias of the world – seem to consistently win more than anyone else; success isn't entirely a dice roll. I like to think of venture as a system of inputs and outputs: those with the best dealflow have the best chance of outsized successes, even if you can't tell which companies those will be in advance. They're rolling a die with 2 sixes on it.

Being creative and proactive with finding opportunities early, investing quickly and with conviction, and levering past successes into strong branding for dealflow (e.g. Sequoia with Apple and Google) is probably the way to win. You're not going to pick your winners, they're going to pick you.

Is operating experience overrated?

It's assumed that you need some sort of experience working at or starting a startup ("operating") in order to be a supremely successful investor. On paper, it makes a lot of sense:

You'll have seen good leadership and operations, and can "pattern match" to it
To help your portfolio companies succeed, you need to have been in their shoes
The best founders want to work with investors that have done it before
The overwhelming majority of successful VCs have operating backgrounds

Then again, lots of things make sense on paper. It's my strong suspicion that operating experience is a perhaps helpful but entirely non-essential part of being a great investor.

I think most of the current narrative is historically arbitrary: over the past 20 years, the classic "road to VCdom" has always been successful founders becoming investors. Those people set the tone, and it's hard for human beings to imagine paths to success other than their own.

Question your assumptions. For those who draw a straight line from operating to investing, I'd consider a few things:

Does pattern matching really exist, given the average 80%+ failure rate?
Do founders really percieve investors as providing valuable portfolio help?
Do all funds across all investments need to beat out competition, and is there only one way to do that?
Does the fact that most VCs have operating experience imply causation, or just correlation? Haven't they also all gone to Ivy League schools?

You can make thoughtful suggestions, offer meaningful help to your investments, and be someone who entrepreneurs want to work with without having been in their shoes. There are plenty of big name VCs who have done that, and there will be plenty more when it's all said and done.

Many startups should not raise VC money.

The progress that the technology industry has made into mainstream society is astounding: the startup and VC world is becoming part of the vernacular and collective thought. With that comes an expectation that the high growth, extensive funding path that the greats took – Uber, Airbnb, and co. – is the path that everyone must take.

It's not.

For all of the positives that venture funding does bring to the table, it also comes with a coerced commitment to a certain company pace and direction: one that includes growth-at-most-expenses and a pressure to manufacture liquidity.

The Indie.vc Flaming Unicorn

Practically, that entails:

A commitment: once you raise any money, you'll always be pushed to raise more at higher valuations (consciously and subconsciously)
Ending up with a sub-20% ownership stake in your own company
Eventually losing control to a board made up mostly of people who aren't you
Tied hands when a liquidity event presents itself before you're interested in it

These aren't exclusively negative: like any legit financial instrument, raising VC money is a tradeoff with corresponding upside. But if you're a founder, you should think long and hard about whether you really want to raise this first round. You'll be (at least potentially) gaining the best business partners out there: but you're also restraining yourself to a very specific, very high risk growth path.

Nowadays, there are middle ground alternatives to traditional fundraising mechanisms (I wrote in VentureBeat about this here). Indie.vc, creators of the flaming unicorn head (signalling the downfall of tech companies valued at greater than $1B), run a new type of fund that focuses on sustainable profits and fundamentals. Lighter Capital provides revenue based financing, so you don't need to give up equity.

VC money might be right for you, and without capital it's difficult to grow at the same pace as your competitors: just make sure you give it thought.

That's it! I hope you liked this, and feel free to share it if you did.