Discussion

The game in Silicon Valley... is not ferocious intelligence or a contrarian investment thesis: everyone has that. It’s not even wealth: anyone can become a billionaire just by rooming with Mark Zuckerberg. It’s prescience. And then it’s removing every obstacle to the ferocious clarity of your vision: incumbents, regulations, folkways, people. Can you not just see the future but summon it?^[1]

It’s never been easy to tell the difference between substance and puff.^[2]

While there still is room for debate in the decision between being a thesis-driven firm or an opportunistic one, this section will assume there is consensus in the firm on the broad investment strategy and analyze the investment decision process. Some firms require unanimous support at investment committee, others believe that the best deals are “non-consensus.”

It seems one broad theme among great investors is intense curiosity. Marc Andreessen “approaches new topics as if starved… until it has yielded every micronutrient…. He turns to theory the way a drinker turns to the minibar.”^[3]

New possibilities are often enabled by a “stack” of other technologies. For instance, Uber could only exist with the iPhone, Android, GPS technology, chip and battery technology, fast wireless telephony, online credit card processing, etc.^[4]

Pacing opportunities seems clever on spreadsheets but it doesn’t reflect the lumpiness of great investment opportunities. “In one out of 3 years, half or more of the best opportunities will come in a single quarter.”^[5]

“Balaji Srinivasan contributed the concept of the “idea maze”: you want the entrepreneur to have spent years thinking her idea into—and out of—every conceivable dead end.”^[6]
Reid Hoffman claims “I look to see if someone has a marine strategy, for taking the beach; an army strategy, for taking the country; and a police strategy, for governing the country afterward.”^[7]

Lakshmi Balachandra found that angel investors tended to follow up with founders that demonstrate character and trustworthiness, more so than passion or competence. In addition, founders that showed they were open to feedback and advice were more likely to move to diligence.^[8]

It is possible to do too much Due Diligence. First, diligence can be of limited value because the best investments often depart from the past, break existing models, and look like bad ideas. Fred Wilson recounts passing on Feedburner because major potential customers said they wouldn’t adopt it, only to be avid adopters six months later. His takeaway was “trust your gut… particularly early on in the development of a company and market.”^[9] Second, rigorous due diligence can drag out decisions to the point where other VCs start laying down term sheets, making the pricing competitive. Third, it has the side-effect of ironing out possibly unique points of view and investment theses. As Chris Douvos says “Oftentimes, the more diligence you do under the guise of “getting smart,” the more your mosaic of facts will resemble everyone else’s.”^[10]

The chart below validates that companies with gender and ethnic diversity are more likely to outperform their peers.^[11]
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Tradecraft

Valuation is most often a function of the negotiation between the lead investor and the management team. The valuation as set by a lead investor is usually is between bands of normal behavior across venture capital, based on known comparables and pattern recognition. In addition, early stage investors choose valuations that both stay mindful of the valuation norms of potential follow on investors (everyone wants a nice markup), as well as protecting enough founder ownership to keep founders motivated.

An article published on the Parisoma blog detailed nine valuation techniques.^[12]

It seems the venture industry only consistently uses comparables, however deeper conversations reveal a nuanced balance between maximizing ownership percentage and two intangible factors: 1) the amount of dilution the CEO and Board is willing to take without souring the relationship at the outset,^[13] and 2) the hope for a mark up price by the set of logical investors at the next stage might plausibly pay if a company executes on their 18-24 month plan.

This kind of “chain reaction” valuation thinking is also problematic, as changes in later stage funding environments elicit intense reactions from earlier stage funders. For instance, when the late-late stage, pre-public “tourists” that had invested at multi-billion dollar valuations started to pull back, many VCs started telling entrepreneurs to “expect valuations 25-40% lower than they might have expected a mere 18 months ago.”^[14]

A more enlightened approach to valuation just might be to coach the entrepreneur, in a way that builds trust, to raise the appropriate amount of capital.^[15]

Tips and Tricks

• Use a quarterly off-site to review your investment themes and theses. Have investment professionals present a proposed thesis several times and embrace the whole partnership pushing on the thinking, research, and strategy. (Emergence)

• Use your portfolio review process to evaluate your portfolio construction, you may find you need to target more deals along a particular theme to diversify, or you may need to find deals that have a shorter time horizon to exit to balance distributions to your LPs. This can affect how you evaluate deals. (SV Health Investors)

• Have no more than three investment themes at a time. If you introduce another, ditch the one that’s generating the least interesting opportunities. (Emergence).

• Distinguish between very specific stages of a deal lifecycle to better manage the process and avoid drop-off.(Emergence)

• As you move from one stage of deal consideration to the next, collect a clear articulation of concerns and areas for additional work. (Emergence)

• Set a limit on the number of deals the partnership can evaluate at any given time. (Emergence: 3)

• Stick to your guns on investment strategy, stick to your own stated criteria. If you don’t, you’re depending on luck. Failing because the strategy didn’t play out is better than failing being all over the place. (Cervin Ventures)

• Founder-market fit is just as important as product-market fit. (Walking Ventures)

• Identify if the company and the entrepreneur have the skills to reinvent their business model, as technology is dynamic in the market. (Monashees Capital)

• Work internally to come up with a detailed diligence checklist before starting to send information requests to company management. (Emergence)

• Do the math on KPIs and operational metrics relative to capital raised and headcount. They can yield important insights.

  • Don’t neglect expenses, particularly sales and marketing expenses relative to company size. (SV Health Investors).

• Use data analytics to find insights on companies they may not even have themselves. (Social Capital Partnership, Learn Capital)

• “The best deals are contentious; if everything/everyone is immediately on board proceed with caution”. (Ludlow)

• For the decision to invest, best to have all partners/team members on board:

  • Even in the case that one partner can push a deal through on their own, the investor team and investee company benefit from a united, excited, and engaged partnership

  • Include all team members/stakeholders in pre-decision updates/meetings to ensure everyone is excited about the deal (Northern Trust)

• Following principles and core strategies are important, but there needs to be a balance to prevent being too rigid, which can lead to missed opportunities (Monashees)

• Have trusted references or a unique network of individuals who you can lean on to give you a technology slant when you are looking at a deal in a particular sector (Greenspring Associates)

• When you’re passing on a deal, send them a formal letter with clear feedback. (Capital Invent)

Tools of the Trade

Tracxn (Monashees) – Offers a strong platform for deal discovery and market landscape data across sectors.
CB Insights – Offers in-depth sector reports, competitive landscape and market trend analysis; offers free daily newsletter.
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Case Studies

Case Study on Emergence: Priority Deals, having a Diligence “Quarterback” and doing Diligence Sprints as a Full Team

Emergence “flips a typical diligence process on its head.” This flip happens in two ways. First, the Monday meeting happens prior to diligence so that the conversation can direct diligence questions. Second, junior team members manage diligence and senior partners do the diligence work first hand in what is essentially a two to three week sprint. According to Jake Saper, Principal, this means that in investment decisions Senior Partners are much more engaged, they have unique information to contribute, and they have built their own perspective based on first-hand information.

Junior Associates at Emergence do not source deals, they run diligence. The first two years of their tenure at Emergence is as Head of Diligence, and the role is one of project manager or diligence quarterback. Compensation, performance reviews, and incentives are aligned to managing diligence.

Generally speaking, Emergence is both picky and slow at getting excited. In order to bring a company in for a Monday partner meeting, at least two team members have met the company and both are excited to bring the deal in. After extended qualitative debate, if every investment team supports the deal and would essentially vote to invest pending certain information and checks, it moves to an official “priority deal” with a list of areas of concern and consideration. There can only be three priority deals at any given time, as it is assumed that the entire investment team will be able to participate fully in the diligence sprint and they can make a decision within two to three weeks.

Once it gets promoted to a priority deal, the Head of Diligence works with the deal lead to come up with a detailed diligence request list. The goal is to send the entrepreneur a single request rather than annoyingly pestering them with continued additional requests.

One of the major diligence requests is always a reference list for both customer reference calls and management reference calls. This is where the full investment team jumps in, as each professional is expected to do at least two reference calls. The Head of Diligence assigns reference calls across the team, and each team member takes their own notes and distributes summaries to the Investment Committee.

The Head of Diligence then parallel processes building a financial forecast from the ground up, understanding the competitive landscape, and diving into and making sense of any funnel, usage, or customer data the company can produce.

In order to make an investment, all five Senior Partners need to have “unanimous enthusiasm” for making the investment. This is why a firm with such a team size and fund size only invests in around six companies per year. Their perspective on the fact that other firms claim their best deals are “non-consensus” is that other firms do not involve the entire investment team in diligence, thus they lack of consensus stems from information asymmetry and the inability to create a unified perspective. Emergence believes their track record demonstrates that this process works well for them.

Case Study on 2B Angels: Diligencing on Values

2B Angels, the family office of Yoel Cheshin, views entrepreneurs through a very particular lens. Most firms view the management team as the single most important driver of success, making the team a critical topic during the diligence process. Yoel views the entrepreneur’s values and worldview as the single most important criteria for deal selection. As an example, one particular founder struck him as “so humane” that he was motivated to invest.

Cheshin wants to add to the discussion on the criteria of an impact investment. Though they believe in and watch a double-bottom line, they don’t see it as a charity. “It is the best way to invest because it shows the greatest potential to show a high return.” Their conviction comes from an expansive view of impact, and a definition of double-bottom line that is more holistic. A company doesn’t have to be inherently addressing a disadvantaged population -- a company could be creating a monetization opportunity for something that is important, like an AdTech company. “As long as the AdTech company is acting with integrity, making ads more relevant and less intrusive, and providing monetization for important organizations, then that’s impact.” 2B Angels believes, for instance, an impact can be created when a startup with strong core values can be assimilated, post-acquisition, to a larger corporation that lacks strength in values. “The DNA of the startup must be included into the DNA of the acquirer.”

During diligence, Yoel looks for entrepreneurs who share 2B’s core values, which might be summarized
as both immutable integrity and a radical focus on continual improvement. Sometimes it takes five minutes to assess this, sometimes months. “It's some kind of frequency.” Yoel believes that doing good will create value, and that transacting business for the sake of business is insufficient. He looks for entrepreneurs who display unique and non-traditional traits. Digging a little bit deeper, Yoel looks for entrepreneurs who “there are people who don't know how to lie, don't know how to be manipulative with others, who want to learn all the time, who are not afraid of evolving, who want to evolve all the time, who are not afraid to ask themselves very tough questions about how they could do things better than what they did.” Cheshin wants to see founders that are “anxious to evolve, and always ask himself what he can change in himself in order to evolve. These are people that are building a startup that we want to have in the world.”

2B’s believes that tactical negotiations over ownership percentages, option pools, valuations, etc, reveal a potential lack of values. “I’m attracted to entrepreneurs who don't think about how many percentage they're going to get, how many percentage I'm going to get, and all this kind of shitty things that people negotiate on.” 2B actually views a hard negotiation as a negative indicator of fit with an entrepreneur.

Highlights

Highlighting Atomico on Thesis Development

Atomico has a fascinating and thorough approach to thesis development that stems from their entrepreneurial DNA. They have a core team member, Tom Wehmeier, fully dedicated to market research. He creates and maintains proprietary data sets and disseminates information on market trends and opportunities to the entire Atomico team. “He’s like an encyclopedia within the firm.” Atomico subscribes to a number of expensive data services so that Tom has access to the best information available. Tom sets the standard for market research for the investment team; associates are expected to do a “massive amount of research every day and around every deal, and share that research back to the team. Tom hosts weekly sessions to thoroughly go over developments in a industry, sector, category or trend, and the presenter rotates across the investment team. If Tom’s information sparks a potential investment thesis, investment professionals will work with Tom to build out their thinking based on research and data. Tom will also respond to ideas from the investment team, he will research anything that anyone on the investment team asks him to and he either validates or invalidates thesis ideas or investment opportunities floated by the investment team. He also works with the Head of Communications to prepare presentations or talking points for the rest of the team when they speak at events, or briefs partners before they get interviewed.

Highlighting Emergence on “Priority Themes”

Emergence has a “priority theme process” in which they work to develop an informed point of view on emerging trends and a distinct way to evaluate companies. At quarterly offsites, investment team members can present a theme they are developing. The presentation will include trends data, category naming with representative companies, prioritizing categories based on data around the market opportunity, the “stack” of products and services that might allow for a number of different emerging companies, etc. Since Jake Saper joined, they have worked on the following themes: Industry Cloud, Enterprise Mobile, and The Coaching Cloud.

Highlighting Atomico on Pushing Through Deals

Atomico has an interesting semi-structured approach to managing their deal pipeline: Find a Sponsor, Validate Conviction. They have a weekly “sourcing meeting” where anyone can float a potential deal, and there is discussion to see if it should go into the decisioning process. In order to get an investment opportunity into the pipeline, one of the investing Partners needs to sponsor it. If Associates or Principals can’t get a partner sponsor for the deal, it doesn’t move forward. If a deal gets a sponsor, it goes into “Validating Conviction” -- which involves discussing the opportunity with the Head of Research, reference calls, etc. The investment decision is discussed in a big all-hands meeting. But, in the end, the actual Investment Committee decision is made by the four Managing Partners in a private discussion.

Highlighting Capital Invent on Clarifying Expectations for the Diligence Process

When Capital Invent moves to diligence, they send the founders a formal letter detailing the values of Capital Invent, outlining the process and timeline, and setting expectations on how Capital Invent will engage with the company during diligence.

Highlighting Social Capital on Quantitative Diligence

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The Social Capital Partnership has a streamlined, proprietary way of doing quantitative diligence called Magic 8-Ball, which aims to standardize product-market fit metrics. In particular, they dive in using a methodology called cohort analysis, which reveals whether the company is getting better over time. Entrepreneurs can use or adapt a query script on their database or analytics tools to generate a CSV file containing key company metrics, and after uploading it Magic 8-Ball generates insights for both the entrepreneurs and the Social Capital diligence process.^[16]
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