Danielle Morrill has put out a fascinating TechCrunch article about the art vs. science of how VC “source deals” (find investments). It’s a rare candid peek into a side of venture capital, and from a perspective, that is foreign to most writing from outside the industry. Danielle is spot on with most of her article, but there are a few glaring holes in the picture she paints.
First, what’s right:
1. Old guard vs. new guard. Danielle is absolutely correct that in VC, as in most professions, the older cohort is in conflict with the newer, rising cohort. And in general, the older cohort is the group that controls the power and the economics: by definition, they’re the survivors who’ve made it to late-career stage and have done pretty well, and so they will tend to bring a status quo bias. Change always threatens the status quo — even in an industry that outwardly worships “disruption.”
2. Cargo cult or “pigeon superstition.” Danielle nails it on the head that most VCs — firms and individuals — refer to “pattern matching” and rely on it to a degree that is often indistinguishable from superstition. Generals are often guilty of “fighting the last war” instead of seeing new situations for what they are, and the same is true with investors.
Now, Danielle is a promoter and a hustler (and I mean both terms in the good sense), and it’s natural for her to think about the world — and to critique the VC industry — in terms of an aggressive outbound sales process. But there’s a problem with this approach. VC is not sales, and seeing only through a sales lens will give you a distorted view.
Here’s what Danielle’s article missed by a mile:
1. Deal Types, and why sourcing doesn’t suffice. From the investor’s perspective, there are two types of VC deals.
- Type 1: Deals that will get done whether you do them or not.
- Type 2: Deals that won’t necessarily get done if you don’t do them.
Type 1 deals are “obvious.” Given decent market conditions (e.g. not in a crash/panic), they are going to get funded by *somebody*. For example: I just heard a pitch from two Stanford grads, one of whom had already started and sold a company, and whose traffic was growing 10-12% a week in a reasonably hot sector. They want a reasonably sized and priced Series A round. That deal is going to happen, no matter what.
If you want to invest in a Type 1 deal, you have to *win* it. You probably have to “source” it to win it, but that alone won’t do. You either need to pay a higher price (valuation), and/or bring more value to the table (domain expertise, industry connections, personal competence / trust).
- Pricing: To be able to profitably pay a higher valuation, you need to have a pricing knowledge edge (which is, in more traditional areas of finance, *the* edge — why do you think Wall Street pays all that money for high-performance computing?). To get that edge, you must know something that other investors don’t about the industry, technology, or people.
- Value-add: To bring more value to the table, you need to have something rare and desirable, and which you can *apply* from the board / investor level. That typically means you’ve previously made deep “investment” of skill, connections, and knowledge in the relevant industry, technology, or people.
Winning Type 1 deals isn’t about sourcing. It’s about front-loaded work: work spent building up knowledge, connections, reputation, skill, etc., and then demonstrating and exploiting that front-loaded work to add value.
Type 2 deals aren’t obvious. Maybe the team is somehow incomplete; maybe the sector is out of favor. Maybe there’s “hair on the deal,” as we say when things are complicated. Maybe there’s no actual company yet, as happens with spin-outs or “incubated” ideas.
If you want to invest in a Type 2 deal, you have to *build* it. It’s true you need to “source” it, but often times “it” doesn’t even look like a deal when you first learn of it. Maybe that means building up a team or negotiating a technology license from a corporate parent. Maybe it means helping make crucial first customer intros (and watching the results). Maybe it means “yak shaving,” getting some of that wooly hair off of the deal and cleaning it up. (I like that metaphor better than polishing the diamond-in-the-rough, but same idea.)
Almost always, it means building a syndicate. That starts with building consensus and credibility with the entrepreneurs and within one’s own firm. Then, it usually means building the co-investor relationship and trust needed to get the round filled out. (For Type 1 deals, it’ll tend to be easy to win over partners and co-investors. Not so Type 2.)
Winning Type 2 deals isn’t about sourcing. It’s about back-loaded work: building up a fundable entity and a syndicate to support it.
2. Pattern matching and non-obvious rationality.
The way that VCs approach “pattern matching” seems irrational when Danielle describes it. Why do those behaviors persist? It’s because they’re rational, in a non-obvious way.
If you lose money on a deal, you’ll be asked “what happened.” If your answer is “X,” and you’ve never encountered X before, there’s a narrative tidiness to the loss, especially if you resolve not to let X happen again.
If you lose money on a subsequent deal, and you also say it’s due to “X,” then things start to get problematic. Losing money on X twice starts to sound like folly. What’s the George W. Bush line? “Fool me twice … um, … you can’t get fooled again.”
If you lose money three times due to “X,” well, then, you will have real problems explaining to your upstream investors why that was a good use of their money. (Even if, in a Platonic, rational sense, it was.)
In an early-stage tech world swirling with risks, so many you can’t possibly control them all, you grab a hold of a few risk factors that you *can* control, which risks — if they bite you again — will have outsized career / reputation / longevity risk for you. And that gets called “pattern matching.”
(The same applies on the upside. If you attribute making money to Y once, it’s nice. But if you make money twice in a row, and claim that it was due to Y, and your early identification and exploitation of Y, you look like a prescient investing genius.)
Now, I don’t believe that the “X factors” and “Y factors” are all meaningless, or that pattern matching is a worthless idea. But even if you did believe that (overly cynical) idea, given the reasoning above, you should still consider it rational for VCs to behave exactly the same regarding “pattern recognition.”
3. Teams do work.
Although Danielle is right that sourcing, winning, and, ultimately, exiting profitable deals is the formula for individual success in VC, that ignores the very real role that firm “franchise” and teamwork can and should play.
Throwing ambitious investor types into the same ring and letting them fight it out like wild dogs isn’t the route to VC firm success. Well, in certain markets it probably works very well — but it’s incredibly wasteful of time and talent to have unmitigated, head-on competition between a firm’s own investors.
No. In fact, teams can and do work. Danielle’s own article manages to quote both Warren Buffett and his longtime partner, the less well-known but still mind-bogglingly successful investor Charlie Munger. Do you think Berkshire Hathaway board meetings are dominated by infighting as to whether Charlie or Warren deserves credit for the latest M&A deal? Hell, no.
Teams work in investing when, between teammates, there’s enough similarity to ease the building of mutual trust and respect, but enough difference to bring something new and useful to the shared perspective. That can be a difference in geographic, sector, or stage focus, as is classically the case. Or, I would argue, it can even be a difference in the part of the lifecycle of a VC investment that best suits a particular investor.
Let’s do a thought experiment. Let’s assume we have two partners in our firm, GedankenVC: Danielle Morrill’s clone, Danielle2, and Charlie Munger’s clone, Charlie2.
Assume there’s a hot new startup out there, let’s call it Software-Defined Uber for Shoes (SDUfS), led by a young charismatic team, who’s intent on building out a social media presence, throwing parties and events to attract energetic new employees, handing out free custom shoes around San Francisco, and otherwise making the best of their recent oversubscribed $2.5 M seed round.
Who’s going to source that deal? Danielle2 or Charlie2? (Sorry, Charlie.)
Now, fast-forward 3.5 years, and everything is amazing, if complicated. They’re on three continents, Goldman Sachs has done a private placement from their private client group, bringing equity capital raised to $600 M, and they’ve floated the first ever tranche of $750 M in Software-Defined Shoe Bonds (SDSBs). Revenues are forecast for $3 B next year, but there’s trouble going public because of regulatory uncertainty around the Argentine government’s treatment of their main on-demand shoe 3-D printing factory in suburban Buenos Aires, and the complicated capital structure. Underwriters and investors are skittish about ponying up for the IPO.
Who should be on the board of directors of SDUfS? Danielle2 or Charlie2? (No offense, Danielle.)
GedankenVC will do best if the person who can source that deal sources it, and if the person who can manage that complex cap structure to exit manages it. Teams do work.
(Disclaimer: I help “source deals” for Seattle-based B2B VC firm, Voyager Capital, but on this blog I speak only for myself.)