Understanding VC groupthink and how to use it to your advantage
Apologies to my many VC friends. I don’t mean to insult or disparage you in any way. You’re all not only brilliant, creative, and successful individuals, but caring and generous people (well, most of you.)
The reason venture funds chase after startups in the same few trendy sectors is not a problem with the individuals. It’s a function of the way the VC system works. Despite all the talk about innovation and disruption, the venture capital system encourages industry-wide groupthink.
Working with a lot of founders, I frequently hear the same complaint: “I’ve talked to 100 VCs, and 99 of them are only interested in software or life sciences. Why do they all invest in the same few things?”
The founders have an important point. If you’re in a hot sector, VCs will fight over you for the chance to invest. If you’re in a space that isn’t sexy, it can be hard to find traction with investors.
Before we can figure out a strategy to attract venture investment, we have to understand what the funds are looking for and why.
What is a Venture Capital Fund?
I often hear a misconception by young entrepreneurs who believe a venture capital fund is a bunch of rich people looking for things to invest in. There is some truth to that, but to understand what venture capital invests in, you have to think of it as a business.
Like any other business, it has managers (general partners) and employees. It seeks to make a profit for its owners. It does that by investing other people’s money.
The first job of the VC firm is to raise money from investors called limited partners or LPs. Once they’ve raised the amount of money they need, say $100 million dollars (called assets under management or AUM), the fund is closed to new investment and the team begins investing the money.
Some of the money will come from the fund’s general partners, but typically only 2–3%. Most of the investment money comes from:
- Institutional investors: insurance companies, retirement funds, university endowments and other organizations that need to invest a large pool of money for long-term returns.
- Corporate investors: large corporations that invest their excess cash
- Family offices: ultra rich people who set up a professional organization to invest their family money
These organizations invest most of their money in bonds, public stocks, and real estate, but many allocate a small percentage to high-risk, high-return investments including venture capital. Rather than investing in startups themselves, which takes time and expertise, they’ll invest in a venture fund which finds and manages startup investments.
Venture Firm as a Business
To pay for the fund’s operations, mostly the employees who have to review all those pitch decks, evaluate potential investments, and work with the startups they invest in, the fund charges a 2% management fee every year. For a $100M AUM fund, that’s $2M per year to run the business.
On top of this management fee is a success fee called the carry, usually 20% of earnings. When a $10M investment in a startup generates a 20x return of $200M for the fund, the venture firm keeps $40M and distributes $160M to the fund’s investors.
Once the firm has invested all the money in the fund, which usually take 2–4 years, other than attending occasional board meetings, there’s not much left to do other than wait for the startups they invested in to be acquired or die.
Since the VC firm already has the team in place and good deals flowing in, it’s time to open a second fund, usually fundraising from the same group of LPs and their referrals.
However, there’s a little problem known as the J-curve. Failures come quickly, but successes take a long time to generate a return. Unlike stocks or real estate funds, it’s hard to tell how an investment in a VC fund is doing until 7–10 years later.
But you need those same LPs and their friends to invest even more in your second and third funds before they’ve gotten anything back from your first. Which means they have to be excited about the investments you’ve made even as many are failing. And here is where groupthink becomes part of the business model.
Groupthink as a Service
Venture firms need to keep their current investors satisfied if they want to raise new funds and retain their lucrative jobs. To do so, they need to show two things:
- They invested in hot startups in hot spaces.
- The failures weren’t bad investments, even if they didn’t work out.
Imagine sending out a portfolio report each quarter. Since 90% of investments fail, there’s a good chance one of the companies in the portfolio is in the process of being closed each quarter, either as a complete loss or at a fire sale price.
If the failed investment was in, say SaaS, the fund can claim it had been a good investment, but the industry hit unexpected tailwinds from the slowing the economy and unfortunately, it didn’t work out.
The investor is likely to shrug. They understand most of the investments in the fund will fail. Oh well. Fortunately, the rest of the portfolio is doing great.
Now imagine instead, the failed startup was developing something more radical, let’s say…teleportation. If it succeeded, it would’ve changed the world. The founders were brilliant physicists. The fund hired respected scientists to double-check the theory. Sure, it was a long shot, but if it worked…it would’ve been the greatest investment ever, easily worth trillions.
But it didn’t work. And now the fund needs to report to their LPs that the teleportation startup in their portfolio failed.
If they’re anything like me, their reaction will be WTF??? Teleportation??? What the hell were you idiots investing my money in? No way I’m ever giving you another cent.
And that would be the end of ever raising another fund.
So if you want to keep your LPs satisfied, every VC knows: never invest in anything that makes you look stupid if it fails. And assume every investment will fail.
Although the LPs are not paying close attention to the specific investments in the portfolio, they are reading the Wall Street Journal every day and talking to other investors.
They won’t know why the fund decided to invest in a particular startup developing silicon-enhanced lithium-ion batteries instead of one of their many competitors. But they’ll know batteries are the key to electric vehicles, and anything that makes batteries lighter, cheaper, and safer has to be a good investment. They’ll be glad they put their money in this fund that’s investing in leaders in the battery space, and happy to invest more in the next fund that’s finding great opportunities in sustainability.
But no, the fund didn’t get into a bidding war with a dozen other funds for the chance to invest in an over-hyped, overpriced battery startup. They were smarter. They invested in less sexy sectors where they could find unpopular, under-priced opportunities. They invested in industrial chemicals, software test tools, and horrors, a beaten-up startup using crypto to solve a difficult problem in real estate.
Now, 3 years later when they’re raising the next fund, their LPs are asking where are the AI startups, the self-driving vehicle software, the cure for diabetes? Why didn’t they invest in batteries, or quantum computing, or Canva? Next time, these investors will put their money into a different venture fund that understands the right sectors to invest in.
In other words, investing in the hottest sectors where everyone else is investing means fund managers and employees are likely to keep their job, no matter how bad the returns. If they stick their necks out and invest in unpopular startups, unless those startups hit it really big really quickly, their first fund is likely to be their last job in venture capital.
Use Groupthink to Your Advantage
As a startup founder looking for funding from VCs, once you understand what VCs are looking for and how they think, you can structure your pitch for success.
Know what sectors are hot. If you can find a way to position yourself as part of one of those sectors, it will make it easier for VCs to invest in your startup.
For example, at the moment, climate tech is red hot. Every fund wants to get any climate tech startup into their portfolio they can find. If there is any way to claim your startup reduces CO2 emissions or increases sustainability, make that the first slide on the deck. Introduce yourself as a climate tech startup, even if that’s a stretch.
If you’re in an unpopular, unsexy category and there’s no way to spin it differently, don’t waste your time on the funds that play follow the leader. Instead, look for funding from:
- smaller funds, contrarians, and funds with a thesis that closely matches what you’re doing.
- corporate venture funds where you fit with the mission and business of the company.
- angel investors who don’t need to justify their investments to anyone except themselves.
- strategic partners who look at your success as an opportunity for their business instead of simply a financial investment.
Another strategy is to grow revenue as quickly as possible since MRR trumps everything. Once the company is expanding quickly, the pitch becomes more about growth rates, CAC, and other financial metrics. If there’s significant cash coming in and happy customers ready to buy more, it’s easy to find investors who don’t look at anything except spreadsheets. Whether the startup is making advanced batteries, teleporters, or women’s handbags matters little if revenues are growing quickly.
Lastly, keep in mind that venture capital is only one way to fund a startup. There are many other sources of funding, from government grants, to small business loans, to customer pre-orders that might be a better fit for a good business that isn’t sexy enough for the VCs that need to justify their investments on their quarterly reports.