What Makes One Investor Better Than Another?

Background

This series will be covering the learnings and reflections of my 6-month foray into venture capital as the guinea pig in Dynamo’s inaugural Venture Fellow Program.

I don’t suppose I’ll be offering any paradigm-shifting views on VC, but I do believe in the value of reframing existing perspectives with fresh eyes. Some latent insight exists in the subtleties not yet acknowledged by previous individuals (Paul Graham’s delta of novelty). The question remains: can you take what’s been said long before and say it more concisely and timelessly? After all, the hallmark of quality authorship in the Information Age is saying more with less.

To cover my bases, the purposes of this series include:

  1. Offering exploratory thoughts on both the VC and supply chain industries as a newcomer, based on real-time experience and not recollection
  2. Maintaining a repository of my thinking throughout my fellowship to refer back to and provide clarity in an autoregressive sense
  3. Having a log for my family to read so I can spend my time on the phone with them focusing more on things other than work

I’ll force myself to stay focused on the areas of VC, company building, and supply chain. Encompassing strategy is beyond the scope of this series. The snippets I come across are the best I can offer. None of the insights are my own, just recapitulations.

Who else might benefit from reading? People engrossed in the world of startups, those thinking about onboarding strategy, and of course, future Dynamo Fellows.

In this first essay, I’m brazenly going for broke in analyzing what truly begets success as a venture investor, calling out dogmatic beliefs, and exposing misconceptions.

Musings

Photo by Min An

At least the useful bits…

What Makes Great Investors?

The highest level of how a deal is assessed among different funds is covered here. Read that before you go any further to see how some of the most venerable in the industry make decisions about how they make decisions. While important to consider, I think the differing processes are more a function of partnership size than anything else.

Process

In picking an individual investment, most early-stage VCs break it down across these dimensions: 1) Do you love the founding team? 2) Is this a venture-scale market? 3) How can we add value?

There are two ways to differentiate yourself in this decision-making process:

  1. Have more useful data than everyone else
  2. Have a better decision-making model than everyone else

Point (1) is the reason why wisdom wins. The VCs who have been doing this a long time know way more (people) than you do. The only way to beat them on this point is to arm yourself with deep, specific (domain) knowledge that they don’t have and can’t easily get. Point (2) is correlated to point one, as the people who’ve been around for a while have had time to test and refine their methodologies. However, overconfidence in these tried and tested methods are a double-edged sword that can lead to entrenched thinking. This opens the door for outsiders to succeed by tying in new knowledge and alternate modes of thinking from other disciplines to gain an edge. More on points (1) and (2) in the next few notes.

Structural Alpha

Source: Financial Times

Branding is even more important for investors than for entrepreneurs. Deal flow is the lifeblood of any VC and your brand is the largest factor driving deal flow. VCs don’t host expos, publish blogs, research, or podcasts as an afterthought or purely out of altruism. It’s in their best interest to grow their brand and bolster the ecosystem (although, never doubt their selfless passion for the industry and the entrepreneurs). These branding efforts are a virtuous cycle, driving the reputation/credibility of the firm, generating deal flow, better terms on deals, and in turn, better return on investment. While these activities seem like play, they may be more integral to the success of the firm than any other operating activity. The corollary is that it’s still all about network — who has the best reputation because over time knowledge concentrates to the most respected parties. This advantage, dubbed structural alpha, is the most important of all.

Proprietary access provides opportunities earlier than others and allows the fund to approach an investment from a unique angle. The ideal would be to get all the powerful people around the world to pull levers for you as needed to create the optimal environment for your startups to succeed. Practically, it provides an avenue to sell founders on why your partnership is the best investment partner among a crowded field of suitors. The “Sage VCs” may have wisdom on their side, but you can always differentiate yourself with hustle and industry-specific leverage.

Inimitable Expertise

Those dynamic factors aside — What makes one investor better than another in selecting investments? Referring back to Don Valentine’s lecture at GSB, VC is the art of asking questions. When chatting with founders, start with asking the right questions, then tactically determine how to ask them in the best way (sequencing, structure, etc.) in order to get them to paint a picture of their vision in your mind. The more pinpointed your question, the more pinpointed of an answer you’ll get. This is the skill of connecting dots and recognizing patterns with incomplete information, then leveraging interpolation and extrapolation to fill in the blanks where critical. It’s a matter of sorting through the founder’s idea maze and challenging her to evaluate how she thinks. Based on her ability to validate her current beliefs and direction, how likely is it that she will be able to think critically and adapt to new problems as the business evolves. This is why startups hire MBA’d consultants as Product Managers. People with strong foundations in critical thinking and inquisitive capacity will naturally apply them to any new problem they face.

Back to the founder, you are trying to determine which assumptions she’s made about the business are upstream and downstream. What this tangibly looks like is illustrating the most accurate picture of where the startup you are interviewing is now, then determining what the OKRs are for the startup to reach the next stage of funding and other key milestones to exit. This whole time is spent searching for the patterns you repeatedly see in successful founders and companies. You should be aware of the dangers of pattern matching though. The world is dynamic and sometimes the inertia from previous successes gets over-indexed. For example, just because most unicorns were founded by males historically, that does not mean this factor is actually causing the success, or that this will continue to be the case. This appeal to tradition effectively prevents you from accurately evaluating the new opportunities you come across. Cognizant of this, how do you recalibrate your thinking? As a form of autocorrect, metacognition is the necessary tool for putting your assessments together quickly while avoiding the common mental pitfalls that beset sound judgment. Moreover, this can’t be just be solved by you. Sure, you may be able to correct for the biases you are self-aware of, but there are always more that you don’t even know you have. Getting other sets of eyes on a deal — having other partners openly covering each other’s blindspots — makes a world of difference.

By now, Kahneman has made it demonstrable that individuals incorrigibly succumb to poor decision making intuitions and other psychological distortions. The best outcomes are generated by the sharpest individuals operating within systems that institutionalize means of obviating mental mishaps. For further reading on this, I suggest you check out Tetlock’s . After all, investing is just forecasting, no matter how it’s framed. Tetlock’s findings are bafflingly counterintuitive, such as expertise inversely correlating with forecasting accuracy. The best teams, like the prototypical Good Judgement Project, consist of members with wide-ranging interests and reading habits. Prodigious of Isaiah Berlin’s pluralism, they are comfortable with ambiguity and contradiction. Tying this back to the point above, the group dynamic is essential. Groups of these individuals perform 50% better than any one superforcaster alone. As such, the way we design our institutions and processes cannot be ignored in creating the best decision-making units possible.

Provenance & Praxis

This is all sounds nice in theory, but how do practically cultivate these skills? The camp that believes ex-founders make the best VCs are grasping at straws, and their opponents corroborate their stance with data.

This is in the same vein as an idea Fred Wilson presented which he referred to as “avoiding the temptation to operate.”

Fred writes:

Amid inconclusive anecdotal experiences and data, I have a pretty strong intuition about this one. One, binary oppositions are essentially a surefire way to make a fool of yourself in thinking intelligently about any category. The belief that one of these paths is absolutely better than the other is just daft. Even relativistically, the supposition that one is generally better than the other is impinged on by chronocentrism. VC is a nascent industry by all measures. And even since its origination, it’s weathered a ton, transformed, and evolved. It’s not the same as when Kleiner Perkins or Sequoia were first formed, or when Bill Gurley and Chris Sacca got their start. As a counterfactual, if the startup scene was as big as it is today 50 years ago — a bunch of these guys probably would have cut their teeth at startups and not in banking, consulting, or law.

Venture capital is unscalable. Production equals the time each partner has.

Bill Gurley, Benchmark

Unlike other asset classes, VC doesn’t scale in the same way. The operational activity is manual and intensive. Each deal is a bunch of man-hours and sizes/opportunity are capped by stage (not to mention geography). At some point, you will max out on the ownership you can take and the amount of reserves you will reasonably withhold for follow-on investment. This is why the trend for emerging VCs is to find new niches within the early stages that larger funds will structurally overlook. The earlier the stage of investment and the smaller your fund size, the more you to rely on bottom-up strategies over top-down approaches. These bottom-up strategies translate to “letting founders guide you to the opportunities” and examining the state of affairs now with perfect clarity. Summarized as, “our job is not to see the future, it’s to see the present very clearly.”

Throw that crystal ball out, you can’t predict anything. What you can do is recognize when lightning strikes.

— Peter Fenton, Benchmark

What Makes Great Entrepreneurs?

How do you know when the perfect storm is here and lightning has stricken? Well, at the top I said it all starts with team. My admittedly facile framework for identifying great teams is as follows:

  • Noble Motivation
  • Learn-it-all (curious, humble, and extremely thoughtful)
  • Founder/Co-founder/Market/Product/Channel/Fund Fit

Depending on how strong the holistic fit is, these territories may overlap each other to varying degrees.

The paragon is depicted within this diminutive area where the planets align and everything converges perfectly.

Lightning has stricken!

MAJOR DISCLAIMER: In limning the above, I must draw a clear distinction between congruence and conformity. For instance, I’m not suggesting that founder/co-founder fit means that founders agree on everything or by founder/market fit that the founders are die-hard industry vets. A lack of diverse perspectives and dissent between these variables begets the exact type of rigid bureaucracy that kills off established companies. In illustrating this point, I’m merely suggesting that in the ideal startup all these variables exist in a sort of pluralistic or hedged balance — coexisting but not entirely aligned.

Great founders are comfortable with paradox and managing cognitive dissonance. VCs target founding teams that will take the seemingly irrational risk of aspiring to create a high-growth business without social proof, but will approach every other risk or decision with the precise, objective (data-driven) calculation of a master logician. Additionally, always factoring into that calculation, the value of new knowledge against the opportunity cost of not deciding in this instant, i.e., bias to action in the face of doubt. As a corollary, you need to have a sense of optimism and a sliver of spontaneity to be a great entrepreneur. This agile and empirical approach is the name of the game in the modern valley, as underpinned by the principles of Eric Reis and Steve Blank. The way I think about it is, you are blindfolded, throwing darts at a dartboard, and if you’re on a smart team at least you’re facing the right direction.

Everyone wants a profound visionary encased within an obedient follower of corporate etiquette. Rarely are those two things found in the same person. Kanye West it best, “If you guys want these crazy ideas and these crazy stages, this crazy music and this crazy way of thinking, there’s a chance it might come from a crazy person.”

Something I think Kanye would also agree with, social proof is bullshit. The burden of proof is on the negative people.

Art & Science

B2B is considerably more clear-cut for early investors. B2C is much more subjective and based on perceived sentiment that can’t be proven to extrapolate at scale with any meaningful certainty. The indicators are more circumstantial and harder to read. Additionally, early-stage specific investors need to be aware that B2Cs, like hardware, are more capital intensive to scale. Consider this dilution risk if not equipped with sufficient dry powder.

Photo by Alex

VCs are averse to investing in solo founders for a whole slew of reasons that have been discussed ad nauseam elsewhere. With that said, a new situation to me is founders that have “half-invested” or part-time co-founders, which is an even bigger turnoff than either polar extreme. It’s a traction disadvantage, and the primary founder has shown no propensity to convince others that his or her business is worthwhile. Building off of this, nobody will deny that at some point a founder will need at least one complementary partner to manage his blind spots and round him out. Great teams are composed of builders (people who understand how the world works) and sellers (people who understand how people work) — A high IQ profile matched with a high EQ profile, aligned with some overlapping domain expertise. The combination of both competencies is rarely found in one individual, especially in highly technical industries. However, just like any other heuristic VCs use, there are always exceptions. The main advantage solo founders have is that they start with 100% of the pie. This allows them to get away with faster burn rates and more frequent fundraises.

FAANG-like dominance is incredibly rare. And I’m not talking from a fundraising, scaling, or exit standpoint. The point I’m after is strictly market share. To secure 70+ percent of a market anywhere near that size for as long as these companies have is rarer than any unicorn. This winner-take-all landscape is much more common for software B2Cs than B2Bs. Companies like Airbnb and Uber have impressive leads, but they are still nascent in comparison. I also recognize using the FAANGs as an example is by no means exhaustive, as there are other great examples, like Intel.

What about layers of removal from an opportunity space? The space itself, then the pick-and-shovel play, then beyond that. Where do you want to play as an investor? It seems about one layer removed (Tier 1) is the furthest you will go before too much external noise clouds the opportunity. For Supply Chain, wherein “moving stuff” is the base layer and the next layer comprises ancillaries for businesses that move stuff.

Time Well Spent

I wouldn’t say any of my time is blocked off for shadowing. Though, there are still plenty of situations where I’m best suited to sit quietly and listen. One of such times was during a particular portfolio company visit. We were doing a post-mortem of our time, “officially”, together. A lot of people talk a good game when it comes to maintaining a culture of transparency, but when it comes down to it, most people still can’t resist the urge to sugarcoat things. This is usually because it’s not clear whether offering fair criticism will serve to strengthen your relationship, but this showcases a lack of foresight. Overcoming that is easy when you have respect and trust undergirding a 3+ year relationship and a clear focus on how the exchange can be used to help both parties operate more effectively moving forward.

Not everything is outsized returns, hanging out with brilliant founders, and LP dinners. Much less of it is than what romanticized media would have you think. What is important to remember though, is that everything you do is to be appreciated for what it is and how it contributes to the broader mission. “The impediment to action advances action. What stands in the way becomes the way.” Or, if you’d prefer the modern rendition espoused by the 76ers and Nick Saban alike, “trust the process.”

The venture business is a bit of an apprenticeship business, so the firm I worked for didn’t let me make an investment until I was 30. That was probably a very smart thing.

– Fred Wilson, USV

One of the few things I was certain of coming out of school was that I wanted to be around as many open-minded people with new and radical ideas as I could. I wanted to accelerate my learning by landing in an ecosystem filled with people of differing perspectives but common values. People with similar intentions, but shaped by different experiences. I was already spending a huge chunk of my free time actively learning about this stuff, and it’s downright fun being a part of this environment. To risk seeming mawkish — with the goal of doing meaningful work with meaningful people, this is certainly one of the best places to be.

Photo by Skitterphoto

There is a spectrum along which sits more outlandish, fallible claims at one end and banal platitudes at the other. An underlying goal of these posts is to engage in an iterative process, refine, and find that right balance—landing closer to a useful truth each time.

The fact that strategy and tactics are always talked about in conjunction with one another is really misleading. According to the latest research, it appears that these are two entirely different skillsets. It may even go so far as expertise in one negatively correlating to expertise in the other.

The more a task shifts to an open world of big-picture strategy, the less the tacticians have to add. Humans crush in open-ended games without objective rules. In fields with known answers AI crushes. In other fields, where me not even be posing the right questions yet, AI is all but useless.

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