Tag: Startups

  • Venture Capital’s ‘Knowledge Work’ Problem

    Venture Capital’s ‘Knowledge Work’ Problem

    While GenAI can improve worker efficiency, it can inhibit critical engagement with work and can potentially lead to long-term overreliance on the tool and diminished skill for independent problem-solving. Higher confidence in GenAI’s ability to perform a task is related to less critical thinking effort.

    source: The Impact of Generative AI on Critical Thinking

    This article is broken down into five segments:

    1. Priorities in venture capital
    2. The importance of cycles
    3. Forcing a reset
    4. The ‘knowledge work’ problem
    5. Operating from strength

    Priorities in Venture Capital

    In colder markets, founders just need capital on reasonable terms, and it doesn’t really matter where it comes from. Value-add propositions and brand strength are less important; access to hot companies doesn’t move the needle as much for LPs. Instead they care more about differentiation through strategy.

    In hotter markets, the opposite is true. Investors will be chasing the fastest growing companies in the most attractive categories, out on the thin ice of excess risk. LPs, sold the same dream, care only about how GPs can parlay their way into those deals. How you invest is irrelevant, what matters is your network and your brand.

    Strangely, at the peak things begin to come full circle. In 2021, when there the incredible amount of capital was spread across a record 1,594 firms, there was a horseshoe effect: with such abundant opportunity for investment, LPs and VCs once again saw the opportunity in strategy-driven alpha.

    The Future of Venture Capital Early signs of disruption suggest how the industry may be impacted

    In normal circumstances, the next stage of this cycle is the crash. The firms that leaned the hardest into chasing heat would be the most exposed, with portfolios that are the most obviously out of alignment with value. What’s left are the firms who chose to focus on solid strategy, who can begin harvesting deals in the down market.

    In 2022, this shift was derailed by the emergence of venture banks, designed to escape the typical cycles of venture. The largest firms raised the most capital in subsequent years. Access remained an important part of the story for LPs, especially with the convenient rise of AI.

    In fact, you could argue that this was the second time that cycle was disrupted, as many experienced investors called the top in 2016-2018 only to be thwarted by COVID. Two years of intense, irrational enthusiasm for digital only exacerbated the problem.

    The Importance of Cycles

    Consider how much of the natural world has evolved alongside fire. Wildfires serve an important purpose in preventing ecosystems from choking themselves to death on redundant biomass, and there are even species that have evolved to use fire as a mechanism to spread their seeds.

    Humanities view of fire as a threat, and the goal of suppressing it entirely in the natural environment, has had disastrous consequences. We have seen the emergence of ‘mega-fires‘, where biomass accumulates to the point where spread is fierce and inevitable.

    There are clear parallels here in venture. The extent to which the market is suffering today is proportional to the amount of time it took to hit a correction. What’s worse, for reasons described above we haven’t yet really allowed the full cycle to complete.

    Forcing a Reset

    While venture banks steam off into the distance, and venture capital tries to figure out how to navigate this environment, there are three signs of change.

    • Increasingly, there’s talk of smaller LPs like family offices looking to pursue direct investing strategies. In theory, this affords them a similar level of risk with better economics, but questions remain about their bandwidth to do this properly.
    • There’s been a surprising number of high profile GP departures, both launching their own funds and not. In many cases, this means partners are giving up wharever carry incentive they had. This suggests some discomfort in the status quo.
    • An increasing number of founders talking about bootstrapping or ‘seedstrapping’ (one and done fundrasing), or other strategies to avoid the problems assocaited with getting on the venture capital treadmill and the expectations involved.

    For the GPs that remain, it’s time to consider what the world would look like if the cycle had completed. How would they be forced to act in a truly ‘down market’ environment. Indeed, if you consider that many smaller firms have been priced out of AI, that may already feel like their reallity.

    It is clear that the bar for performance is significantly higher in a cash constrained environment with higher interest rates. While that may not change the reality for venture banks, it is existential for traditional venture capital.

    The ‘Knowledge Work’ Problem

    In hot markets, where investors take a prescriptive approach to investment, there is a huge problem with atrophy. Completely separate to the poor investments that come out of these periods, it’s also worth examining the practices they establish.

    Investors that spend all of their time chasing hot deals based on a number of set criteria have the same basic problem as knowledge workers that rely on Generative AI solutions: they are not using their critical thinking muscles. Executing orders, not problem solving.

    Consider how little actual thinking you have to do about an investment if your process is focused on second-order factors. Is it on an a16z market map, is it on YC’s Request for Startups, are other “tier 1” investors are in the round? Will downstream investors will give you the markups you need, and will LPs will be excited about it?

    This behavior, geared towards capital velocity, is focused on second order information and pattern matching. It is a prescriptive approach that informs what gets investment, displacing the first-order considerations about things like team, opportunity, valuation, market and strategy.

    This dissertation focuses exclusively on moral hazard, which refers to a venture capitalist’s propensity to exert less effort and shirk their fiduciary duties to the investors to maximize their self-interest; specifically, a VC’s propensity to choose subjective selection criteria over more cognitively taxing objective criteria when faced with multiple options and fewer resource restrictions.

    “Venture Capitalists’ Decision-Making Under Changing Resource Availability”, by Noah John Pettit

    While this approach might broadly work for venture banks, with an army of low-impact investors looking to index across new technology trends, it will not deliver the returns required by the traditional venture model.

    Operating from Strength

    The contrary to prescriptive investing is quite literally the hunt for outliers. Backing illegible companies. Being consensus averse. Resisting what have been the loudest models.

    This might sound like cowboy investing. A Rick Rubin-esque vibes based approach to venture capital. It certainly can be, and if you happen to be Rick Rubin it might just work — but why take the risk?

    The way for these investors to operate from a position of strength is to build process alpha. That is, do everything you can to prevent being wrong for predictable reasons (controlling for bias), and to manage the risk of being completely wrong a lot of the time (portfolio construction). Not to overintellectualise investment decisions, but to give yourself the strongest foundation to embrace the risk of uncertainty.

    To take the analogy a bit further, for all that Rick Rubin is a total eccentric, guided by his own taste without the need for external validation, he is not cavalier about it. He pays immense attention to environment and routine in order to help him get the best return on his time.

    There’s never a need for investors to stray from this disciplined mode of operation, it just so happens that most are prey to the cycles of venture capital and the temptation to inflate fees when opportunity arises.

    Discpline is easy when opportunity is limited.

  • Venture Banks

    Venture Banks

    In venture capital circles, the most widely discussed trend of 2024 (outside of AI) has been the concentration of capital into “venture banks” like Andreessen Horowitz, General Catalyst and Thrive Capital. The household names of venture capital have had a blockbuster year, while others carefully ration the tail-end of their last fund. 

    The first quarter opened with Andreessen Horowitz and General Catalyst scooping up 44% of the available capital. 2024 is closing on a similar note, with 9 firms having captured more than half of all funds raised so far. The 30 most capitalized firms this year collectively represent three quarters of the pool raised by at least 380 funds. 

    However, the real anomaly is not how much the large funds have raised, but rather how poorly everyone else has done. Why has the bottom fallen out of the market for smaller funds, if the giant firms are still able to vacuum up capital? 

    There are a range of opinions on this question: Consider the insights shared by Sam Lessin, in The Venture Capital Regatta; Yoni Rechtman in Return, Bifurcation or Megafund Dominance; or Charles Hudson, in Three Future States of the Early-Stage VC Ecosystem. Both are respected investors with valuable perspectives but a slightly different set of base assumptions, so triangulating on objectivity is difficult. 

    Ask a hundred GPs or LPs where they draw the line between small funds and large funds, or how they define multi-stage and multi-sector strategies, and you will get a hundred different answers. The lack of standard definitions and common understandings has dramatically hindered productive discourse about venture capital over the years. 

    Importantly, it has obscured the manner in which multi-stage venture capital has diverged from the rest of the market. Today, it operates a novel model for startup investment, targeting a new class of LPs with a very different premise.

    A Rapacious Playbook

    In 2011, Jay Levy of Zelkova Ventures wrote an article about the conflicting interests involved in insider pricing. His point was simple: when investors led rounds for existing portfolio companies, their desire for greater ownership would be outweighed by their need to show performance. 

    Two things are striking about this article:

    1. Jay’s concern probably seems alien or overly-dramatic to anyone who entered venture capital within the last decade. Today, it’s just the game on the table. 
    1. It is also likely to be the single largest contributing factor to the pricing bubble that grew during ZIRP and exploded in 2022, if you follow the incentives created. 

    In a rational market, where VCs are all stage-specific, each round of investment has a different lead investor. That means, at regular intervals in the company’s development, it will be valued by a neutral third-party. Outside investors that want to maximize ownership will go up against founders that want to limit dilution. From that tension, we expect a generally fair outcome to emerge. 

    Venture capital relies on this tension, and the increasing financial savvy of investors as the investment moves downstream, stewarding companies toward exits. From qualitative analysis at the earliest stages to the quality of cash flow at maturity; you move the dial from founder strength to financial performance as you go from pre-seed to IPO, and so the expertise of investors evolves in parallel.

    Multi-stage firms have a different (and fairly rapacious) view on this process. Instead of inviting scrutiny of the value of their portfolio companies, their strategy is to keep that in-house, or within a network of associated firms. Rather than rational pricing through the tension of buyer and seller, they have embraced the jagged edge of what Jay Levy described: why worry about valuation if pricing can be a competitive advantage? 

    Want 3-4x markups on investments to show LPs? Just do subsequent rounds at 3-4x and get them rubber-stamped by networked investors. With “performance” taken care of, it’s easier to raise more capital to feed portfolio companies, fuelling aggressive growth to grow into those markups. It’s putting the cart before the horse, compared to conventional venture thinking, but it has a certain brutal charm.

    So, we’re beginning to see that the ‘capital as a competitive advantage’ playbook didn’t expire with ZIRP. A decade of cheap capital was what it took to prove the model, and today it just needs a different class of LP to back it. Indeed, multi-stage GPs appear to have spent 2023 with their heads down, consolidating around the best-looking secondary opportunities (SpaceX, OpenAI, Anthropic, Anduril) ahead of a grand tour in the Middle East. Sovereign wealth, with giant pools of capital and no great pressure on liquidity, are complementary to the traditional large institutional LPs for this strategy. 

    Exploiting Venture Capital’s Flaws

    As multi-stage firms have expanded their funds under management, they’ve had to similarly scale their ability to capture market share. This has been solved through a fairly innovative list of features, each of which exploits a different dynamic of venture markets: 

    Platform Teams: Leaning into size as an advantage, multi-stage VCs have built platform teams with the advertised intent to offer support and resources to portfolio companies. In reality, portfolio teams are the serfs of the venture world, managing the burden of a large portfolio for a relatively small team of partners while generally adding little value for founders. 

    Signalling Risk: VCs are wildly vulnerable to herd behavior. An example of this is “signalling risk”: concern about the signal of how other investors respond to a startup. Despite being obviously silly, this essentially means “tier 1” firms get prima nocta on every founder they touch, so they scoop them up en masse with scout programs and EIR initiatives. 

    Backing GPs: While the rest of the market struggles, multi-stage funds can raise additional vehicles through which they become LPs in emerging managers. They look like the good guys, supporting the underdogs, broadening the market and encouraging competition. In fact, they are entrenching centralized positions in the relationship model of venture capital.

    Operator Investors: In the last decade, there has been an ideological shift towards the idea of ‘operator investors’. Former founders are seen as the ideal archetype for venture capital, having first-hand experience building companies. As it turns out, they don’t really make for better investors, they’re just extremely well networked and have credibility with founders.

    Procyclical Pricing: A huge amount of valuation wisdom has been discarded over the last decade, as the industry as a whole adapted to deal velocity with cruder pricing models—e.g. revenue multiples, raise/ownership, etc. These common practices lack critical specificity and amplify volatility in the market, a problem for venture firms that rely on rational pricing.

    The Value of Venture Beta

    The product of this multi-stage approach to startup investment is “venture beta”: returns will broadly track the market, while they expand in network, assets, and market share. For the largest institutional LPs, like sovereign wealth, this is fine: acceptable returns with minimal volatility, and they can brag about funding innovation with the support of the most prestigious firms.

    Further out, this model’s success depends on whether it can produce companies that are attractive to public market investors or private market acquirers. Up to now, large infusions of capital with crude pricing have produced sloppy, undisciplined businesses. The IPO market is still reeling from being force-fed companies with poor financial health in 2021. Whether this misalignment can be fixed, or is inherent to the strategy, has yet to be seen.  

    Some early stage VCs have commented that multi-stage VCs still rely on small, contrarian firms to identify opportunities before they are ‘legible’. It seems more accurate to say that small firms are just another source of signal about new market opportunities for the mutli-stage strategy, rather than a crucial part of the chain. Scout programs, hackathons and accelerators all create redundancy for the competence of small firms in this capacity. 

    For Those Seeking Alpha

    While historical patterns would indicate that the funding will bounce back for everyone else next year, it is worth some urgent reflection on how the growing share of multi-stage capital influences the market. 

    In the short term, multi-stage firms tapping into a new LP base shouldn’t have a huge impact on smaller funds, although many of their usual LPs will be spooked by the shift. GPs should have a good answer for how they adapt to this reality. How can they compete against the capital, network and brand strength of multi-stage firms in future? With increasing skepticism about the “value add” from venture capitalists, what do they offer founders that the multi-stage firms can’t?

    For GPs with high domain expertise in hard sciences, there is enough evidence of outperformance to differentiate them from large generalists. For everyone else, the burden of proof is going to be higher than ever, and will require becoming disciples of venture theory: Read everything there is about portfolio construction, historical performance, decision making, biases and strategy, and build a rock-solid case for LPs that you deliver on the two critical fronts:

    1. The potential to deliver excellent returns, in contrast to the mediocre performance of the largest firms. Not by swinging for the fences on every hit, but with properly optimized portfolio, price discipline, and solid understanding of the underlying theory. 
    1. Backing the best founders with the most important ideas. However good a multi-stage fund gets at identifying early stage opportunities, their model will always bias towards consensus themes and capital-intensive ideas. It is a limitation. 

    Essentially, GPs of smaller funds need to meet divergence with divergence, and embrace the strengths of their size and strategy: contrarianism and discipline, which amount to a form of value investing for early stage companies. Finding the easily overlooked. The alpha. 

    The Fork in the Road

    Multi-stage GPs spent the last decade cosplaying as VCs, despite their practices being opposed to the conventional rationale of venture capital. You can’t make good judgements about price vs value or question consensus themes if your existence is predicated on assigning arbitrary markups and chasing the hottest companies.

    Over the last decade, many VCs have sought to emulate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions. It has also produced some extremely poor practices, and bad attitudes.

    The more VCs study the history, theory and current reality of private market activity, the more conviction they can develop about their own mindset as investors. The more confidence they have, the better they will fare as individuals in a discipline where peer-validation is poison and the herd is always wrong.

    If that’s not for you, then there is a lucrative future to be had working at a venture bank. 

    But you need to decide which path to take. 

  • Venture Capital Abandoned Deep Tech and Is Paying the Price

    Venture Capital Abandoned Deep Tech and Is Paying the Price

    The venture capital industry, once lauded for its role in fostering innovation and technological breakthroughs, has lost its way. The pursuit of hyperscalable software companies, fueled by incentives tied to management fees and opaque valuation practices, has led VCs to prioritize short-term gains over long-term value creation.

    This shift has effectively sidelined deep tech startups in favor of software ventures that, while initially promising high margins, often end up as structurally unsustainable and unattractive in the eyes of public markets and acquirers.

    The liquidity crisis and the collapse of valuations post-2022 are, to a large extent, the result of this myopic focus.

    Markups, Management Fees, and Misaligned Incentives

    The core problem lies in how venture capital funds are structured. Many VCs earn their income primarily through management fees, which are a percentage of the assets under management (AUM). In this framework, VCs are incentivized to raise as much capital as possible and deploy it rapidly, not necessarily into companies with the strongest long-term potential, but into those that will generate high markups quickly. The logic is simple: markups create the illusion of success, which can then be showcased to Limited Partners (LPs) as evidence of strong fund performance, enabling VCs to raise subsequent funds and further increase their management fees.

    However, the criteria for these markups are alarmingly arbitrary. Without standardized metrics for valuing private companies or clear data collection methods, VCs have significant leeway to set valuations that align with their own interests. The result is an ecosystem that disproportionately rewards companies that raise as much capital as possible, at the highest valuation they can achieve, regardless of their underlying business fundamentals.

    This creates a vicious cycle where capital-intensive, rapidly scaling software startups are favored over deep tech ventures. The latter, which often require years of research and development before reaching commercial viability, do not fit neatly into this model. They lack the frequent fundraising rounds that VCs rely on for quick markups and cannot be easily measured using ARR multiples which have become the venture capital industry’s (moronic) North Star.

    A Crisis of Venture Capital’s Own Making

    The 2022 downturn in venture-backed company valuations, especially in the SaaS sector, was a long time coming. For years, VCs funneled billions into software companies with the promise of high margins, rapid user growth, and scalable business models. But as these companies matured, the flaws in this strategy became apparent. Many of these SaaS businesses, initially rewarded for their revenue growth, began to reveal cracks in their unit economics and competitive moats.

    In the public markets, where profitability, defensibility, and cash flow become the ultimate measures of value, these companies failed to meet expectations. The high-growth software playbook that worked so well in the private markets could not withstand the scrutiny of IPOs or M&A, leading to today’s slowdown in both exits and later stage valuations.

    The outcome? VCs are now sitting on portfolios filled with overvalued, underperforming software companies. The lack of attractive exit opportunities has created a liquidity crisis, trapping capital in companies that may never deliver the returns expected.

    The Opportunity Cost

    Amidst this frenzy for rapid scaling and quick markups, deep tech has been left behind. Yet, ironically, it is these deep tech companies—whether in biotech, space tech, or hardware—that have the potential to deliver outsized returns and societal impact. Unlike SaaS companies that can be replicated with relative ease, deep tech ventures are built on defensible intellectual property, technological breakthroughs, and years of research. Their competitive moats, while difficult to establish, are significantly harder to erode.

    Deep tech is fundamentally misaligned with the current VC incentive structure.1 These startups will take much longer to mature. They may not need to raise subsequent rounds until they have proven their solution, which may mean lengthy R&D cycles without easily measurable increase in value. This means fewer markups, less frequent fundraising, and, consequently, less “performance” to show to LPs.

    The paradox is that while deep tech may not deliver immediate returns, its potential for outsized impact—both in terms of financial returns and societal benefits—is far greater than the current crop of SaaS investments. If successful, deep tech companies can redefine industries, create entirely new markets, and generate returns that are an order of magnitude higher than those seen in the overfunded software space.

    The Return to Venture Capital’s Roots

    The original mission of venture capital was to take on the risk of funding transformative technologies that traditional finance would not touch. Semiconductors, biotech, and early internet technologies were all enabled by patient capital willing to bet on the future. However, over the past decade, this ethos has been replaced by a focus on capital velocity, management fees, and the illusion of quick wins.

    The solution to the current crisis is not simply more capital or better timing. It requires a fundamental realignment of venture capital with its original purpose. This means rethinking how funds are structured, how incentives are aligned, and how performance is measured. VCs need to shift away from the obsession with ARR multiples and markups toward a focus on genuine value creation, technological defensibility, and long-term impact.

    In essence, the liquidity crunch facing the VC industry today is self-inflicted. By prioritizing short-term returns over sustainable value, VCs have created portfolios filled with fragile businesses ill-equipped for the demands of public markets. A return to deep tech, with its focus on defensible, transformative technologies, offers a path forward—not just for the VC industry but for the broader economy.

    The future of venture capital should not be in chasing the next SaaS unicorn but in rediscovering the roots that built the industry: funding the innovations that will shape the next century. The hard pivot toward deep tech is not just a strategic necessity—it is a return to the true purpose of venture capital.

    1. While there are welcome signs of a hard tech rennaisance in places like El Segundo, it remains an uphill battle and is largely misaligned with venture capital incentives. Indeed, the fact that companies like SpaceX and Anduril had to be started by billionaires is evidence of venture capital’s failure. [↩]
  • 6 Measures to Correct VC Incentives

    6 Measures to Correct VC Incentives

    1. VCs taking public money (pensions, sovereigns, etc) must publicly disclose all deals, terms, marks and position changes.
    2. LPs managing public money must publicly disclose all fund positions and cash returns.
    3. Tax treatment for anything up to ~series A should be extremely advantageous to small managers.
    4. No passing public money through multiple layers (e.g. VCs acting as LPs to EMs).
    5. LPs managing public money should not offer bonuses to their allocators based on short-term performance.
    6. LPs managing public money should have something similar to polical rules around disclosing gifts, travel, hospitality, etc.

    This is just a start. The highest level changes that should be made to correct some of the perverse incentives in venture capital today, providing adequate accountability for public capital.

    There’s much more to talk about in terms of diverging small AUM and large AUM managers, or standards for valuation and reporting marks, but that starts to get deeper into the weeds.

    First, we need to be concerned with how pension money is being invested and the long-term implications that has on the startup funding and innovation.

    Giant pools of capital being awarded and invested in an unmeritocratic manner have a toxic influence on the venture market.

    Originally posted in response to a question by Brandon Brooks, here.

  • The Rot of Short-Termism in VC

    The Rot of Short-Termism in VC

    Venture capital is a seriously long-term game, with investments taking somewhere between 8 and 16 years to return liquidity.

    The distance to that horizon creates a lot of eccentricity.

    For example, VC does not reward following patterns or navigating market movements, neither of which is relevant to decade-long cycles. Consensus of pretty much any kind is toxic, as the more people agree with something the less profitable it becomes. Investment experience is like comfortable entropy, slowly eating-away at your ability to remain objective.

    In a sense, success itself is antimemetic: the better the outcome of an investment, the more likely you are to try and repeat it through pattern matching — destroying the calibration which allowed you to find it in the first place.

    Can you imagine how maddening that is?

    This is why the best GPs are oddballs. They live with the paradox that being a ‘good investor’ is a process of constant discovery, and the more lost you feel the better you are probably doing.

    It takes a certain madness to do well, and that is not something you can pick up on the job. You cannot be taught how to think in a contrarian manner. Nobody can give you the confidence required to wait a decade to see if you have good judgement. You have it, or you don’t.

    This is why great VCs earn a lot of respect. The role they play in financing entrepreneurial dreams is critical. From the semiconductor origins of Silicon Valley to SpaceX and our future on other planets, someone had to be there to write the check.

    If the incentives were well aligned, that’s where this story would end — as a fan-letter to weirdos. VC would remain a cottage industry investing in wacky stuff, offering strong returns for LPs.

    Unfortunately, that is not the case.

    Over the past decade we’ve seen the emergence of a new type of VC: one who moves between trends with the swagger of a heat-seeking missile, investing as if their money might go bad. This behavior is contrary to pretty much everything that we know about venture capital, and yet the trend has only accelerated.

    To understand why, we have to look at VC compensation:

    The ‘2 and 20’ structure of VC compensation is pretty well understood and has remained unchanged for a long time: You get 2% of the fund per year in ‘management fees’ to pay your bills and support portfolio companies, and 20% of ‘carried interest’ as a share in any profits made.1

    For people passionate about the outliers, carried interest is the hook. Secure enough big wins and you can make a vast amount of money, in contrast to management fees which aren’t exactly lucrative for a small fund. It’s also nice that carried interest aligns success of the firm with success of the founders.

    However, as capital flooded into private markets over the last couple of decades, and exits took longer to materialise, some cunning individuals recognised an opportunity: the 2% is guaranteed, independent of performance, and it is possible to ‘hack’ venture to maximise that income.

    You can do things the old fashioned way, raising (for example) two $100,000,000 funds in a ten year period, with the implied annual income of $4,000,000. Alternatively, you can squeeze three funds into that period, at double the size, and scale your income to a mighty $12,000,000. All without really needing to worry about underlying performance.

    To build that second scenario, you need to do three things:

    • Invest in the most overheated, capital-intensive industries, which allow you to justify raising and deploying larger funds ever more quickly. These industries are also an easy-sell for LPs, who want something to talk about at dinner parties.
    • Systematically undermine the understanding of valuation by promoting crude and illogical practices, and calling people nerds if they say things like “free cash flow”. Venture is a craft, not a science — which basically gives you carte blanche, right?
    • Pour capital into brand and status building for your firm, which LPs love. Celebrities, political figures, impressive offices, big events… Anything that shows them you’re a serious institution (with the perks that entails) and not some garage-band firm.

    Instead of looking 8 to 16 years in the future with your portfolio, you want to focus on the next 2 to 3 years in order to align with your fundraising cycles. You want companies that are likely to grow in value rapidly in the near future, so hype and consensus are powerful allies.

    The aim is to invest in a company at Seed and propel it to a Series A within 2 years at a 4-5x markup, which — if you can repeat it often enough — will look great to LPs. If they ask about DPI just talk about how the IPO markets should open next quarter next year.2

    It doesn’t even matter if you don’t think your portfolio companies are attractive investment with that markup, as there’s no obligation to participate. You have the growth on your books to help you raise the next fund, and some compliant downstream bag-holders, that’s all that matters.

    You can even build this strategy into how you price deals. Rather than try to objectively value the business, just tell founders to think about what a reasonable Series A price would look like for them, and then divide it by 3 for the Seed. That way, you’ve got the expectation of at least a 3x markup already built-in to the investment!

    You want to make sure the heat persists, to ensure prices at later stages remain frothy and your markups get better and better. So consider a bit of thought leadership to keep interest on your chosen sector. As long as LPs believe the hype, and keep investing in other funds on that theme, capital will keep piling in. Amplify that market momentum as much as possible. Volatility is your friend, and over time it can even help you wash out smaller managers that offer an unfavourable comparison on performance.

    Obviously the actual investment returns from this strategy are likely to be terrible, unless you’ve somehow timed another ZIRP/2021 exit phenomenon and can unload all of your crap on the public markets just before the music stops. It doesn’t really matter, because the median return in VC is so poor that you might just luck your way into top quartile anyway. Keep the paper marks strong, keep bullshitting LPs about the market conditions and the insane potential of whatever it is you are investing in, and you can probably keep buying back in with a new fund.

    It’s going to be toxic to founders, as they watch huge piles of capital being incinerated chasing hype instead of genuine innovation.

    It’s going to be toxic to innovation, as founders increasingly choose to pursue ideas that they think VCs will back, rather than real passion projects.

    It’s going to be toxic to VCs, as good practices around markups, pricing and portfolio management are ditched in favour of capital velocity and short-term incentives. It’s already frighteningly clear how much basic investing knowledge washed out of VC during ZIRP.

    It’s going to be toxic to LPs as already pretty shitty performance metrics for venture capital get even worse.

    1. The management fee is often frontloaded and scales back after the investment period. The 20% carried interest may also have a hurdle rate (e.g. 8%) which guarantees some return on investment for LPs before they split profits with the VC. [↩]
    2. It might not matter though, as many institutional LP allocators collect their bonuses on markups, so their incentives are totally aligned with yours. They’ll probably have moved on to a new job in a few years anyway. [↩]
  • VC has trust issues, not a liquidity problem

    VC has trust issues, not a liquidity problem

    In a strange twist for an asset class built on patient capital and outsized returns, finding liquidity for investors has become a matter of urgency for VCs.

    On the surface, this is a story about venture capital’s evolution and fund managers adopting more sophisticated liquidity strategies. Pry a little deeper, and you’ll find LPs reneging on capital commitments, pushing VCs to secondary markets and expressing disappointment with activity over the last few years. Now, some just want to cash out. 

    Gradually, and then suddenly

    The average age of private companies exiting through an IPO has advanced from 7.5 years in the 1980s to 11 years in the 2010s, as both regulatory and macroeconomic factors have brought more capital into private markets.

    The cash-rich environment allowed companies to grow into loftier valuations with relatively little scrutiny, while benefiting from the scrutiny of their public peers. For many this seemed like a winning strategy, with projected outcomes that were often jaw-dropping, and some VCs began talking about 15 year liquidity horizons. Significantly, there was no outcry from LPs; distant horizons were the name of the game, and the theoretical scale of returns bought a lot of patience.

    Large private firms are thriving in part by freeriding on public company information and stock prices. Such firms’ astonishing ability to attract cheap capital may last only so long as public companies continue to yield vast, high-quality information covering a broad range of companies.

    Elisabeth de Fontenay, Duke Law: The Deregulation of Private Capital and the Decline of the Public Company

    So why the sudden pivot to seeking liquidity in the last two years? Why are investors now so concentrated on returning capital? Is there more to this story than interest rates?

    Overheating the market

    The basic proposition of venture capital is that LPs commit a certain amount of capital to a VC fund and are returned some multiple of that over the following decade.

    There are two unique considerations for potential investors in venture capital:

    1. VC firms will typically deliver weaker returns over subsequent funds, with many top performers being emerging managers with smaller funds. 
    2. The asset class lacks a meaningful standard for measuring current fund performance, with firms ‘marking their own homework’ to some extent. 
    Pitchbook: Private market fund performance

    This combination makes it challenging to identify promising VC funds; track record is unreliable and performance is opaque. What remains for LPs is networks and trust, explaining why so much focus is put on relationships. These relationships, and over a decade of ultra-low interest rates, have allowed VCs to get away with longer periods of illiquidity and slipping rates of return. 

    The assurance offered, in place of returns, centred on the mounting theoretical value of venture portfolios. Venture-backed companies were raising vast sums from investors who thought of valuation as an ‘arbitrary milestone’ in the process. As long as the number kept going up with each new round, the investment looked good. This approach allowed VCs to raise ever-larger funds, extract more in fees, deploy more capital to inflate valuations further… and the wheel kept turning.

    In theory, LPs were set for historic returns, as soon as those companies hit an exit. 

    The venture funding freeze 

    How many poorly-performing tech IPOs does it take to put public market interest on ice? In 2022, we found out. 

    While some point the finger at interest rates for spooking investors towards the end of 2021, the evidence of a correction was there from earlier in the year as many high-profile tech IPOs saw a rapid collapse in share price. There was a clear disconnect between tech valuations and a public market which no longer had faith in what they were being presented. 

    Crunchbase: The Biggest IPOs Of 2021 Have Shed 60% Of Their Value

    This was the consequence of venture capital’s exuberance. Shifting the focus to crude measures of current value had corrupted pricing discipline to the extent that exits were no longer viable. Any path to liquidity required coming to terms with huge markdowns, backtracking on the promised returns and damaging the trust of LPs.

    To say that, in hindsight, it would have been a good idea to sell more stock in 2021 is to ignore the underlying irrationality. Had VCs been inclined to sell, valuations wouldn’t have been so high to begin with. 

    It was not that the strategy was bad, it was that there wasn’t one. 

    The path ahead for venture capital

    VCs created this liquidity squeeze by exploiting an opaque market and increasingly divorcing price from value. This is precisely what needs to change in order to foster a healthy secondary market: greater transparency, discipline on valuation.

    Specifically, a secondary market will only work if it is perceived to be where VCs sell their winners at a reasonable price, to account for shifts in risk profile outside of their portfolio focus. In this scenario, the incentives are built on transparency. Conversely, if the perception is that secondaries are for firms to offload companies that investors have lost faith in, then the incentives are built on obscuring or misrepresenting performance. That asymmetry leads to adverse selection and the slow death of any market it touches. 

    The future of venture capital has to involve greater transparency and stronger standards, to rebuild relationships with LPs, enhance market efficiency and access to liquidity. That vision requires the careful consideration of incentives, built on a fair and rational approach to understanding the value of venture investments. It means eliminating trust from the equation. 

  • The failure of due diligence (in Fintech)

    The failure of due diligence (in Fintech)

    For as long as there has been business, there has been fraud, and ‘cooking the books’ is about as old as it gets. In recent years, the extreme focus on revenue has produced dangerous incentives for founders and investors to cut corners. Those chickens are now coming home to roost.

    Now a regular feature in tech media, we’ve seen a growing number of cases in which startups have been caught fabricating revenue (and associated metrics like accounts, deposits, transactions, etc). Given the focus on financial performance for venture backed businesses, it has left the impression that you might escape scrutiny if your numbers look good at a glance. 

    The most recent examples include Banking as a Service (BaaS) up-and-comer, Solid; financial aid startup, Frank; notorious cryptocurrency exchange, FTX; and mobile money interoperability provider, Dash. It’s not deliberate that all of these examples are Fintech companies, though it does appear that Fintech is the sector most commonly associated with revenue fraud.   

    (source: Contextual Solutions)

    Is this a consequence of the fundraising environment? Is there a deeper problem in Fintech?

    The pressure of hypergrowth

    While venture capital has taken a much more moderate tone towards growth in 2023, with mentions of ‘quality revenue’ and ‘sustainability’, this wasn’t always the case. Up until early 2022 the strategy du jour was raising huge amounts of capital at inflated valuations in order to fund aggressive growth to try and justify said valuations.

    Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis.”

    Bill Gurley, GP at Benchmark

    Nowhere has this been felt more keenly than in the Fintech industry, a darling of the venture capital industry since the post-financial crisis wave of evolution kicked off around 2010.

    (source: Pitchbook)

    The startup-led digitalisation of financial products, including the ability to scale at a rate far surpassing incumbents by using a different playbook (see how Revolut has scaled internationally by adhering to just the regulatory minimums), has driven incredible revenue growth for Fintech in recent years. 

    After achieving more than 500% growth in 2021, the juggernaut Fintech growth finally began to stall in November. We can speculate on the reasons, but the chief suspects are the impact of COVID’s Omicron variant on business confidence, the beginning of the current surge in inflation, as well as growing fears of deeper economic woes spurred by the pandemic. 

    None of those factors will be much comfort to founders who will continue to try and live up to the expectations of the extreme growth demonstrated in 2021. For many investors, the benchmark has been set and the goal is to return to it, for the sake of their fund performance.

    Smoke and mirrors 

    Even at the best of times you will see a range of behaviours, from subtle manipulation to outright fraud, in startup financials. With so much on the line, and relatively little accountability, there’s a clear incentive to cut corners.

    Combine that with the heights of ZIRP-drunk behaviour in 2021 and you will see real problems – even unintentional. An example of this would be PayPal’s admission that 4.5M fake accounts had been created to abuse their sign-up bonus schemes at the time. This admission was shortly followed by revised revenue projections, as they realised the huge outlay of capital was not going to yield the returns they had hoped.  

    (source: PayPal quarterly reports via American Banker)

    Consider also how startup investments have been priced in recent years, with revenue multiples becoming the easy shorthand for valuation. In a 30x industry, as Fintech was at the peak, $1M in revenue became $30M in value – and due diligence wasn’t keeping up. Revenue was poorly scrutinized to begin with, and now it was having an outsized impact on fundraising.

    The magnification of value produced a powerful incentive for founders to exaggerate revenue with any trick imaginable…  of which there are many: ‘round tripping’, reporting gross revenue rather than net, sketchy definitions of ‘booked revenue’, or treating discounts and refunds as expenses rather than contra-revenue events. For many, it became common practice to fudge revenue reporting (to varying degrees) in order to inflate performance and exaggerate potential.

    When I joined Flexport as co-CEO in September 2022, I found a company lacking process and financial discipline, including numerous customer-facing issues that resulted in significant lost customers and a revenue forecasting model that was consistently providing overly optimistic outputs.

    Dave Clark, former co-CEO of Flexport

    Unfortunately, conditions only worsened when the ZIRP-hangover began. After the leg-sweep of funding early in 2022, investors were briefly forgiving about slowed growth in the new environment but it didn’t last long. Today, founders are expected to live up to the kind of growth they had previously promised investors, without necessarily having the available venture capital dollars to afford it, all while angling more aggressively towards profit. 

    The crunch is real, and it will lead many founders to make bad decisions. 

    Challenges for investment due-diligence 

    A much discussed side-effect of the ZIRP-era coming to an end, with the collective tightening of belts in venture capital, is the resumed focus on proper due diligence with startup investments. This will include things like debt, leases and contracts, as well as the startup’s current and projected revenue. 

    This may already be catching out the lies from startups that exaggerate revenue to bump their valuation in a previous fundraising round, but it’s not always as clear cut. For this, we can look at the sordid history of GoMechanic, a startup caught in a revenue-faking scandal despite previously having sign-off on its accounts from Big Four accountants PwC and KPMG. The third time was the charm when EY finally managed to nail down where things were going wrong, including all kinds of accounting chicanery in a partially cash-based business. 

    This begs the question: how realistic is it for investors to catch-out revenue fraud for private companies, when there is so little in the way of enforced standards? Public companies are expected to adhere to GAAP (Generally Accepted Accounting Practices), but no such obligation exists for private companies. ASC 606 and IFRS 15 exist as revenue recognition standards for both private and public companies, but will continue to be ignored by startups for as long as they aren’t required by investors or properly scrutinised by board members. 

    For Fintech investors especially, this prompts the old debate about whether investors need to be experts in the industry in which they invest. If you are a partner at a financial services company (venture capital is really just a peculiar financing product), investing in financial services startups. should you not therefore have at least a minimum of financial literacy? 

    To go deeper down the rabbit-hole: there are questions about how much investors knew about some of these cases, before they were brought to light. When is it of interest to an investor to intervene, and go through the messy process of righting the ship, even when it may mean revising value downward for other investors, founders and employees? What if they just kept quiet, and let it be someone else’s problem?

    Diligence isn’t cool; do it anyway

    Increasingly, issues appear in the world of private company investment (and are amplified in the high risk/reward world of startups) which relate to a stark lack of transparency, accountability and regularity. 

    If venture capital firms invest in startups with the expectation that they will one day exit via IPO (and thus adhere to GAAP), why do they not require prospective investments and  portfolio companies adhere to those standards from day one?

    Startups are volatile in performance and unconventional by nature, making it impossible to standardise much about how they operate. In fact, I’d go so far as to say that conventional business wisdom is a plague on founders. However, much can be standardised about the ‘unsexy’ aspects of the fiduciary duty between founders and investors. 

    Founders are probably not jumping at the chance to apply accounting standards to their business. It is far easier, unless obliged otherwise, to sketch out an income statement with a  degree of improvisation. A certain amount of poetic licence goes a long way for VCs, too.

    However, it’s clear we are entering a new era for startups, with fresh scrutiny across the board – especially for Fintech. The world of startup investment is, slowly and painfully, moving towards greater levels of accountability. 

    We should also think carefully about the operating system of startup fundraising, and whether it really incentivises the best behavior and the best outcomes. I am a ‘techno-optimist’ in that I believe in the power of efficiently allocating capital to innovation… but that means real innovation, not monkey jpgs.

  • Deus Ex Machina

    Deus Ex Machina

    The success of AI is existential for venture capital

    Imagine entering VC in 2020, full of enthusiasm about a the unstoppable wave of technology. Your peers are impressed; it’s a prestigious industry that is perceived as commanding a lot of power through capital.

    You have to put aside your personal thesis in favour of the firm’s strategy on crypto, micromobility, rapid delivery, creator economy, and web3. Each of those sectors are benefitting from venture capital enthusiasm and weaponised capital, driving prices through the roof. It’s an exciting time, though you’re not feeling as involved as you would like to be.

    In fact, you’d quite like to make the case for investment in other industries; overlooked opportunities which offer larger ownership stakes and cleaner cap tables. It’s difficult to justify the change of strategy when the biggest markups are all coming from a few hot sectors, so you avoid the friction.

    Andreessen and Sequoia can’t be wrong, right?

    Capital is flowing into the asset class from LPs at an unprecedented rate. Rather than pressure to justify and properly diligence investments, you are pressed to ensure capital is deployed and opportunities aren’t missed. Access to hot deals and co-investment with the tier-1 firms is how you stay relevant to LPs. Success is now largely dependent on your relationships across the industry.

    It creeps up on you that your colleagues have stopped talking about exits. TVPI looks phenomenal. There’s no rush for any portfolio to go public. Now the conversation is about pricing and the appetite of downstream investors. Beyond that, it’s someone else’s problem.

    For the first time, your spidey-senses start to tingle.

    Early in 2022, concern ripples across the industry. Worries of recession, interest rates on the rise, and a weak public market that has lost interest in recent VC-backed IPOs. In simpler times, you would have papered over the cracks by highlighting fund resilience. Now, the idea fills you with dread. None of your portcos are growing much and auditors are on your tail to correct markups.

    With surprising speed, the tables turn. An era of unprecedented growth and optimism comes to an end. Y Combinator writes the eulogy with an open letter to their portfolio companies. Venture-backed hypergrowth is shelved in favour of finding a path to profitability. The red-hot sectors which had promised game-changing returns are quietly scrubbed from websites and bios.

    By Mid-2023, venture capital feels like a fever-dream. Many of the most exciting investments from 2020 and 2021 have imploded or recapitalised. Layoffs are the norm, even for many VC firms. Nobody in the arena wants to talk about why.

    Fortunately, nobody has to dwell on the cause of the downturn for too long: exciting new tech from companies like OpenAI and Midjourney provides the perfect source of distraction. A whole new gold rush to sell to LPs.

    The incredible possibilities offered by powerful, accessible AI models will spawn companies with growth potential not seen since the early years of Google and Amazon. It promises to easily turn-around a few years of poor performance for the venture asset class.

    Of course, there are nay-sayers. Not the doomers who speak of an AI-driven apocalypse, at least they buy into the incredible scope of the technology. They are believers. The real problem are the cynics.

    The cynic’s claim is that today’s “AI” is just an evolution of decades-long work on machine learning, neural networks and natural language processing. Yes, the hardware is a lot better, processing at scale is much easier, but fundamentally not a huge amount has changed. Models will be commoditised and commercial applications will favour incumbents who have data and distribution. It’s not the generational game-changer that venture capitalists claim.

    Those who believe the hype (or those whose career depends on it) preach the gospel of salvation for an entire generation of managers. The narrative battleground is shifted to the conflict between these two groups, the doomers and the boomers, away from the cynics who offer nothing but grim reality.

    Evangelism reaches new heights. Marc Andreessen who led the charge on the 2011 – 2022 bull run with his essay, “Why Software Is Eating the World“, proclaims even greater optimism with the publication of “Why AI Will Save the World“.

    It gnaws at you. Do you really believe? Do the numbers make sense, or is venture capital back at its usual bullshit? Is it your responsibility to just blindly support this as an insider?

    Worse, what if this fails too? The consequences for the venture asset class are difficult to contemplate.

    At some point, you are sure the music is going to stop.

    Until then, the only path you can see is to continue following your peers. As long as you are all doing the same thing, no failure can be pinned on you.

    …Right?

    Each day you scramble to find the hottest AI deals in your network and secure allocation. You keep making the same promises and assurances.

    You lean into the identity, blend into the herd. Any sense of irony in wearing the uniform disappears. You begin to believe.

  • Larian’s unfair advantage

    Larian’s unfair advantage

    This post was inspired by two things I saw recently:

    • Jonny Price of WeFunder, sharing their newly designed raise page, featuring some giants of tech like Substack, Mercury and Levels.
    • Xalavier Nelson Jr. of Strange Scaffold, commenting on the seemingly extreme success of Larian Studios, with the upcoming release of Baldur’s Gate, and imporing consumers that it not “raise the standard”.

    The connection between these two items is not obvious, but it is interesting.

    The lemon problem

    WeFunder, for the uninitiated, is a crowdfunding platform for (primarily) technology companies. It allows community-oriented startups to sell a small % of ownership to their users and supporters.

    Unfortunately, crowdfunding faces a stigma which some refer to as ‘the lemon problem’. Essentially, “why are you raising from unsophisticated retail investors when you could get backing from a top tier venture capital firm?”

    This signalling issue then discourages the best startups from pursuing crowdfunding, which (in theory) lowers the overall quality available there, reenforcing that crowdfunding is a negative signal.

    The problem with that concept is that it is dumb, and built on a decade of putting venture capital on a pedestal.1

    Crowdfunding, or ‘community rounds’ as Jonny would prefer, offers a path for users and supporters to become advocates with ownership and incentives aligned with your own. You can offer them perks, you can treat them as your Customer Advisory Board, and you can usually rely on them to help disseminate your message.

    Unfair advantages

    So where does this connect with Xalavier, and Larian?

    We’ll begin at the end, with Xalavier’s comment:

    Like a lot of people, I’m deeply excited about what the lovely folks at Larian accomplished with Baldur’s Gate 3, but I want to gently, pre-emptively push back against players taking that excitement and using it to apply criticism or a “raised standard” to RPGs going forward.

    Xalavier Nelson Jr. on the expectations set by Baldur’s Gate 3

    He goes on to cite a number of reasons why Larian has been advantaged in the development of Baldur’s Gate. Particularly, their experience with this style of game, and the importance of the IP they have secured from Wizards of the Coast.

    He’s right on all counts. Larian is – today – in an unparalleled position as a developer of RPG games. They have great experience, multiple studios, a supportive community, and a huge IP.

    You could, if you were a peer of Larian’s, a fellow game developer, feel a bit like they are operating in a league above you. That there’s an unfair advantage, and any comparison between their work and yours would be unfair. Punching down.

    Unfortunately, Xalavier stopped there. He didn’t finish the thought. He never asked why Larian has this advantage, to determine whether or not it is unfair.

    Kickstarting a dream

    Back in 2013, Larian was a relatively small games studio. They did ‘mercenary’ work for other studios to help pay their bills while developing their own string of medium-budget RPG titles.

    Their work was quality, but they couldn’t compete in the big leagues. Studios like Bethesda, Obsidian and Bioware were effectively household names, and threw resources into pushing the envelope of what RPGs were offering.2

    Larian were ambitious, though. Swen Vincke, the studio head, had been an RPG fanatic all the way back to Ultima 7, and he wasn’t done trying to carve a path in the genre. As they began developing their next title, Divinity: Original Sin, they ran into a problem: it was more game than they could afford to make, but they couldn’t afford to make any less. They needed a break.

    Funding for games is notoriously difficult. All of the costs come before you make a penny in revenue, and there are usually few indications that you’ve made something players want until release. Many games flop, and many studios fold. It’s not an attractive area for institutional investors. So Larian turned elsewhere, to their community, and the wider community of RPG fans.

    In 2013 they launched a Kickstarter campaign for Divinity: Original Sin. They aimed to raise between $400,000 and $1,000,000 to support development, by offering everything from ‘gratitude’ to an invitation to the launch party depending on how much was contributed. They clearly laid out what each benchmark in funding would mean for the game, and the player’s experience.

    They didn’t quite hit the $1,000,000 mark, but they did raise $944,282 from close to 20,000 individuals. An average contribution of almost $50 each, from a vast but not cash-rich audience, into the dream of a great RPG.

    It gave Larian the cash they needed to get Divinity: Original Sin out of the door, and it was everything they had hoped for: a landmark RPG which put the studio on the map, and laid the groundwork for everything they would do in future. Ultimately, their work inspired sufficient confidence from Wizards of the Coast to give Larian the rights to develop the Baldur’s Gate franchise with this hotly anticipated sequel.

    Community driven growth

    Over the next few years, covering the eventual launch of Divinity: Original Sin in 2015, the even-more-succesful sequel in 2017, and up until the imminent release of Baldur’s Gate 3 today, Larian has experienced the benfit of that crowdfunding round.

    More than any other factor, raising money from an audience of customers (and potential future customers) has meant that Larian has never had to compromise. They were not at the mercy of institutional investors or publishers to hit hasty development milestones or add supplementary revenue streams. They could build the game as they wished, by a group of RPG enthusiasts; for an audience of RPG enthusiasts. They are self-sufficient, and happily so.

    We’d tried multiple times with third parties and we listened to them every single time, and we had to learn that it was important that we took our own fate in our own hands. And since then, things have been going on the upside for us.

    Swen Vincke on developing Divinity: Original Sin

    This alignment of incentives between product and customer is fundamental. It’s how companies should work at the best of times, but the need for external capital can often complicate the relationship. Larian went right to the source.

    And that is their ‘unfair advantage’, that they were able to focus entirely on their vision to build a fantastic product.3 Exactly as every company should, in theory.

    Equity in the equation

    Larian’s crowdfunding success was built purely on the promise of what their product could offer to customers, and how additional capital would strengthen that proposition.

    In the world of startup financing, equity crowdfunding takes this concept and injects it with steroids. Revolut’s crowdfunding round in 2016 has since created more than 100 millionaires, and the company has attracted more than 4,000 retail investors to date.

    These may not necessarily all be users of Revolut, but they are individuals who believe in the future of the company, will recommend it to others, and will contribute to the future growth of the company.

    This is why I’ve long been enthusiastic about crowdfunding as a source of capital for startups. And while that includes the obvious consumer companies with network effects and tangible investor perks, it also includes many successful raises from business-facing deeptech companies who are producing radical innovation.4

    Be like Larian. Make community your unfair advantage.

    1. How is that going, by the way? [↩]
    2. And each had, in their own way, at a previous point in time, earned that place in the ‘big leages’. [↩]
    3. It has also allowed them, more recently, to build this supportive community into their development pipeline. Early access for Baldur’s Gate 3 will have lasted for an unprecedented three years before official release, during which time they have relied on that community for feedback and vital testing capacity. [↩]
    4. Why VCs are failing that sector is another subject, but if you’ve read many of my recent articles you may be able to piece that together yourself. [↩]
  • It’s all about identifying outliers

    It’s all about identifying outliers

    What startup investors can learn from sports betting

    Early stage investing is a complex and relatively new practice, which makes it fertile ground for analogies which can help explain the more abstract concepts to both newcomers and veterans alike. 

    In this particular case, grappling with the intrinsic value of pre-revenue startups, there’s an interesting parallel to sports betting. Fundamentally, both involve looking at the strength of a team and the competitive landscape and making a judgement on future potential.

    What we’re considering here is the idea that a startup – even a pre-revenue startup – has a determinable value even before that value has been tested in the form of a market transaction. This is also what you might call a ‘fair market’ valuation, which is what we aim for at Equidam. 

    MOIC vs. betting odds

    In early stage investing, investors will look to benchmark potential returns using a metric called the multiple of invested capital (MOIC). MOIC is calculated by taking the total potential return on an investment and dividing it by the amount of money invested. For example, with an investment of $100,000 in a company with an expected MOIC of 10, the company should have the potential to return $1M.

    In sports betting, participants measure their potential returns using the odds of winning, which represents the probability of success. For example, if the odds of a team winning a basketball game are 9:1, it means the team is assumed to have a 10% chance of winning and the return would be a multiple of 10. 

    Rewarding the earliest participants

    In both examples, the earliest (successful) participants receive the most lucrative returns. In investing, this is because early investors are able to get a lower share price than later investors. In sports betting, this is because early participants are able to secure better odds.

    In both cases, this is for the same reason: At the very beginning there is the least available evidence to indicate an assumed outcome, thus a greater level of perceived risk associated with the choice. This is true both in terms of signals from other participants (other bets or investments made) as well as actual progress in terms of milestones achieved, such as games won or revenue secured. 

    Qualitative and quantitative measures

    In early stage investing, investors use a variety of qualitative and quantitative measures to judge the potential of a company. Qualitative measures might include the management team, strategic relationships, and the competitive environment. Quantitative measures include things like the company’s projected financial performance, market growth and associated risk. This is reflected in the form of the valuation, which ultimately informs the potential return on investment.

    In sports betting, participants use similar measures to judge the potential of a team. That might include the team’s roster, their experience together, track record of the coach, and the threat posed by other teams. This is reflected in the form of a perspective on what the betting odds should be to provide appropriate upside for that level of risk.  

    What this means for early stage investors

    According to some, a startup does not have a valuation until it has been priced in an equity transaction. To an extent (in a strict and formal sense) that is correct. It does not itself have a valuation, because value is not an objective concept. Like beauty, it lies in the eye of the beholder. However, we shouldn’t pretend that an equity transaction represents an ‘objective’ read on value either; it’s also just the opinion of an investor.

    What this analogy illustrates is that you, as an early stage investor, should have your own personal read on valuation as a reflection of future potential. You need to understand the qualitative and quantitative factors involved, and determine a practical framework to run your own analysis. It’s the best way to sharpen your judgement on future potential, take an informed perspective on risk vs return, and put your money to better use.

    If you are investing your own money, it’s not crucial that your valuation framework be seen as objective or fair. Many investors look at valuation primarily in terms of market context and what other investors are doing. Others use simple heuristics like national averages adjusted with a few qualitative measures, even if that screens out some deals. Whatever approach you use, if it allows you to reach your desired level of returns then it is clearly working. 

    When being objective is important 

    Imagine it’s January 2023, and a friend is looking to place a bet on the upcoming NBA championship, and you – being wise and well informed – recommend putting money on the Denver Nuggets. This is a team which hasn’t won a championship in its 47 year history, and a year ago they lost in the first round, so the odds are great (in terms of MOIC) but your friend will take some convincing. 

    It’s in explaining this opportunity to another person that objectivity becomes important; your rationale must survive without the support of your own biases and perceptions. What are the data points which conclude that the Denver Nuggets have been overlooked or undervalued by the market? What is it about their 2023 roster and the wider competitive environment which indicates for success? How do you piece that into a compelling story for your friend? 

    This is, again, mirrored in the world of early stage investment. If you are looking for input on the potential of a startup – which has not yet been rubber-stamped in a market transaction – you will want to see it in a transparent, objective format which covers all of the key indicators. This is applicable in a range of cases, whether that is determining a valuation for the first round of a company, proposing a valuation to a group of angel investors, or reporting updated valuations to your LPs.

    This is where we finally arrive closer to assigning a ‘fair valuation’ to a startup, rather than the individual perspectives on valuation. Not a number determined by the combination of gut-feel and Excel-gymnastics designed to pattern-match past success, but something scrutable, explainable and repeatable. 

    Crucially, valuation can be incredibly useful even when it’s not associated with a market transaction. In fact, the single perspective of a lead investor on the value of a company is potentially less valid, and less reliable, than a more objective framework.1

    Backing outliers is the whole ballgame

    Early stage investment pivots around uncertainty and valuation is always a tricky exercise in assessing the tangible and the intangible. Reaching 100% efficiency in the risk/reward is never going to happen. 

    Similarly, your friend doesn’t have to buy every data point in your recommendation, they just have to understand what you are looking at, the conclusions drawn, and appreciate that it was a rational process with an outcome they can challenge or disregard as they wish. 

    Had they made their bet based on the odds at the start of the season, following the favourite as indicated by the market, they’d have lost their money. Had they waited a few months to see how each team performed in order to inform their judgement, they would have increased their chance to pick the right team, but with much lower potential returns.

    And that’s the argument in a nutshell. In order to understand an opportunity while the terms are most favourable, or to explain that opportunity to others, you need to think about practical and objective measures of future potential. Early stage investing is all about identifying outliers, like the Nuggets, which is precisely why we approach valuation from this perspective. 

    1. Especially given the extreme proclivity of investors to pass the buck, and base their pricing on other market transactions. [↩]