This is gold, I would read this blog post pic.twitter.com/vdPbq7n6YW
— Jarrad (Moose) Lawrence (@JarradLawrence) November 3, 2022
I was playing around with a new AI that attempts to tweet like the author (you can try it out here) and Moose Lawrence posted this example, meant to be something that I’d be likely to tweet.
To my surprise, the more I looked at this tweet’s assertion, that “for startups, the best VC is the worst VC”, the more I started to realise what my AI bot doppelganger meant.
In what circumstances can “the best VC” become “the worst VC” for your startup? And perhaps even more interesting: what might make one of “the worst VCs” be “the best VC” for your startup?
For all the other unverified Twitter bots out there reading this column, I’m going to do my best to answer both these questions today!
When the best VC could become the worst VC
Great VCs can be bad for startups because of how they try to manage their risk, how they tend to pattern-match when evaluating potential investments, and how they may sometimes tend to try to force too many of their portfolio companies to adopt the same template for success as the best-performing companies in the portfolio.
The risk of being a VC
Maybe we all get so caught up in the risky, arduous journey of leading a tech startup that we forget (or never realise) just how risky and arduous the journey is for the founders of a venture capital firm too.
At the beginning, most founding partners in a venture capital fund are expected to contribute a significant chunk of their own savings to the fund, as a show of faith in their own ability to make smart investments. Then, they are expected to go without a salary (or a salary vastly below market rate) for an unknown amount of time, certainly until the venture firm has enough of its investors’ capital under management that the typical 2% management fee starts to cover office space, staff wages, marketing and travel expenses.
If you’re doing well, it’ll probably be at least four to five years before the founding partners are able to earn a market salary, and in the meantime, whatever the management fees don’t yet cover, comes out of the founding partners’ pockets. What makes it all worthwhile for the founding partners is their share of the “carry” — the profits derived from selling the fund’s stake in the portfolio companies they’ve invested in.
But they don’t see that carry hit their bank account until all those shares in startups have been sold to someone else, (which mostly won’t start to happen until years 7-10 of the fund) and then, only after the fund’s investors have received an amount equal to that which they first invested in the fund.
It’s also important to remember that the vast majority of funds under management have been provided by external investors (“limited partners”) who are expecting an exceptional rate of return from their investment.
Like, 5x-or-more their money back. Although most funds managed by VC firms have a ten year period to deliver that high return, most investors will begin to forecast the eventual return outcomes based on what they see in the performance of the fund in its first three-to-five years.
A VC’s hot streak needs to last for a ridiculously long time
All of which means that all venture capital firms — even the best ones — are being managed by people who are motivated to make it appear like they know exactly what they’re doing, all the time, even when perhaps they don’t (at least, not always). And they have to keep that going for the full ten year life of the average fund.
When ‘black swan’ events occur ( like, oh, say, extreme weather events magnified by climate change, a reality TV star becoming US president, a global pandemic, widespread famine, a collapse in economic growth in China, and a war in Europe) a venture fund manager needs to be able to retain the confidence of their investors. They need to be assured that, while nobody could really have foreseen these black swan events occuring, the venture fund is still on an even keel.
The longer a venture capital fund manager maintains a reputation as a successful navigator of challenging times and a great pick of future startup value, the more valuable that reputation becomes, and the bigger the impact on the individual and the firm, if that reputation is lost.
This is what leads to pattern-matching behaviour
It’s just human nature for any of us to repeat behaviour that has led to success for us in the past.
So if a VC’s reputation was built on the back of investing in, say, SAAS startups founded by two CIS white male ex-Atlassian engineers and targeting the mining industry, the VC needs to do a lot of work on themselves to combat both the conscious and unconscious bias that might otherwise lead them to favour similar SAAS startups founded by a couple of CIS white male ex-big-SAAS engineers that target industries similar to mining.
Most of the time, the only counteracting forces motivating them to work on those internal biases are a conscience and a belief that with greater portfolio diversity comes better financial returns. And as a VC’s reputation for picking winners continues to grow, so does the volume of new deals that cross their desk.
Why learn more about new industry sectors, new technologies, and how to relate to founders who aren’t CIS, white and male, when repeating the same patterns that delivered you success in the past helps you deal with processing the increasing number of inbound pitches you receive?
Don’t tell investors which other investors are interested
Maybe you and your fellow CIS white male ex-Atlassian engineer cofounder just had a great first meeting with one of the ‘A-List’ tech venture capital firms, or maybe, because they’ve been really working on their biases, a partner at an A-List firm has been meeting with you even though you don’t fit their template for previous success.
You’re excited about how interested they are, and you know their name carries a lot of weight in the industry, so when you go to your next investor meeting, and they ask you, “who else is looking at investing in this round?” it’s a huge temptation to drop the name of the A-List VC.
Don’t do that, not even if you are holding a term sheet from the A-List VC in your hot little hands! Don’t name names of individuals or firms. Why?
Because the strong reputation of that savvy partner at that A-List VC swings both ways; other investors put a lot of stock in what the savvy partner is interested in, but also in what the savvy partner decides they’re no longer interested in.
If you’re trying to get an angel investor or another fund’s team to commit to the investment round, the worst signal they can receive is when that widely-respected investor, who you’d humble-bragged about previously, decides in the end not to proceed with the investment.
Seeing an A-List firm walk away from an investment round before it closes is a sure-fire way to make other investors lose faith in the deal too, and is probably the most common way a great VC can be a bad VC for your startup.
We need you to be more like Startup X
Once a firm has decided to invest in your company, they are all going to want to give you advice, support and services, to a degree.
It’s cheaper and easier for them if all their portfolio companies use the same legal, accounting, recruiting and marketing service providers. It reduces the reporting headaches if you all report your metrics in the same format using the same reporting tool.
It helps them market their next fund to their existing investors if it’s easier to develop a narrative around an investment hypothesis that suggests a certain kind of tech startup is the secret to the success of the VC firm. And if you’re not that kind of startup when they first invest in you, there may often be subtle or not-so-subtle encouragement to become so.
I believe that each tech startup is special, unique and different, and as hard as we try to make the next generation of startups look and behave like the last, history shows us clearly that it’s the outliers, the misfits and the oddballs that deliver the outsized successes.
Every A-List VC firm I know has something like, “we’re here for the outliers, the misfits and the oddballs” in their marketing copy, but you should take a look at the portfolio and make up your own mind whether the curtains match the drapes, so to speak.
When can the worst VC be the best VC for your startup?
If perhaps we define “worst” as new, unknown, without-a-reputation, and “without much of a full service offering” then maybe the worst VC in town might be the best VC for you, at least, at first.
The fund’s partners are just getting started and they need to write some cheques into some new companies without further delay — most funds write all their first cheques in the first two or three years of the fund’s ten year life. If they over-optimise for due diligence they are likely to take too long, and investors will become frustrated with a perceived lack of action.
So new fund managers sometimes (not always) tend to be more open to ‘outside the box’ startups and founders who don’t fit the traditional mould.
A fund or a fund partner without much of a reputation at risk is less likely to damage your chances of closing a round if they decide to pull out before the round is completed, so I would have no trouble with telling potential investors that we’ve received a term sheet from Brand New Tech Ventures, whereas I would be very wary of telling another investor the identity of the A-List fund that had sent me a term sheet.
Just say it’s one of the A-List funds, with your best cheesy grin.
Finally, a new fund is less likely to try to get you to conform to their portfolio norms — to grow your ARR as fast as the fund’s top three performers, to hire your CFO from the same bank they hire all their other CFOs from, or to adopt goal-setting and reporting standards that aren’t likely to ever be a great fit for your team and your startup.
Sometimes, the best VCs can be the best VCs for your startup. But not always. And that’s why the bot’s not wrong on this one!