“Linear is a late entrant in a world filled with collaboration apps, and specifically workflow and collaboration apps targeting the developer community. These include not just Slack and GitHub, but Atlassian’s Trello and Jira, as well as Asana, Basecamp, and many more.”
Imagine looking at the dev collaboration space as a seed VC in 2019. It would be a tremendous leap of faith to believe that there could be space for a new entrant in a market with multiple scaled incumbents and indie products.
How were Sequoia and Index able to pull the trigger then on the Linear deal? My guess is because they followed the core philosophy of top-tier seed investing, which I have myself seen play out multiple times in my career – “that seed bets are all about the team, and that overthinking the market & competition at this stage adds fatal blurriness to what should be a sharp team-centric seed lens.”
I have studied the anti-portfolios of many legendary VC firms spanning decades, as well as connected the dots with key misses of VC firms I have personally worked with or closely observed in my career. A dominant theme across the anti-portfolio set is getting distracted by overstudying the ‘market’ and as a result, overlooking what was a star founding team.
A nuance to this “team vs market” point that I have tried to incorporate is that as long as the market is directionally correct and, more importantly, the team has a strong fit with it, I pretty much give it a checkmark at my end and quickly move on to spending most time evaluating the founders.
PS: btw, I have a similar observation on seed entry valuations as well. Will cover it in another post!
The enigma of junior VCs toiling-away to create market maps.
Probably one of the most mind-numbing jobs for a junior VC must be creating these frikkin’ market maps and thesis visualizations.
Imagine churning for days/weeks on a landscape doc, only for it to be obsolete in a few weeks/months with how AI is evolving.
And who do these docs eventually serve? Can’t think of them creating any real value for seed founders. Perhaps LPs?
These market maps remind me of the “market slide” that all consulting/IBs have in their deck. Hardly any customer cares about them much. They end up becoming junk collateral that some analyst/associate toiled hard to put together.
Btw this reminds me of when I was a junior VC. I had to ghost-write articles for the Partner and in the end, not even get credited for it. Even as a 27-year-old, I found it extremely discomforting that having joined the VC industry to invest in and support founders, I was spending inordinate time helping the GPs market themselves.
My (subconscious) revenge for the ghostwriting days? After a decade, have now turned blogger & podcaster with my own brand (An Operator’s Blog – blog + podcast) + investing in founders with my own world-view & conviction (my Fund Operators Studio), not begging GPs to “get a deal through”.
Most investors try to “slot” startups in their heads, whereas extraordinary venture outcomes lie in the “slot violations”.
A few weeks back, I was helping a portfolio founder put together the story and deck for raising the next round. This company is one of the true category-creators I have seen in my career and has now reached a PMF tipping point that will lead to explosive growth going forward. Customers and channel partners are literally pulling the product out of the company’s hands, and all metrics are going up and to the right.
Despite this, the founder was sharing how difficult it still is for him to explain the business, the market opportunity, and how this is an extremely differentiated play to investors. Having seen this startup’s thesis play out as an existing investor, my conviction on it is 200% but despite powerful operating signals, it’s still non-trivial to put together a narrative that investors “get” immediately.
This isn’t a new pattern. I have seen this repeatedly play out with truly groundbreaking companies, simply because most investors prima facie, try to “slot” the company in their heads within the first few minutes of the 1st meeting. These slots are pre-existing buckets created by years of pattern-matching, and not surprisingly, 90% of startups can easily fit into one or more of these slots – eg. big company exec stepping out to start an enterprise company, young engineers hacking a dev tool, repeat founder building in the same market, generalist founders executing really fast in SaaS etc.
The issue is this – history tells us that extraordinary venture outcomes are created in the narrative violations (or what I now call “slot violations”). These are companies that are hard to understand in the present moment, being built by founders who are quirky and/or with non-obvious backgrounds, or resulting from messy pivots. Well-known examples include:
When Evan Williams was shutting down Odeo and hacking around with a micro-blogging tool (which eventually became Twitter), it had no business model even in the foreseeable future.
Imagine how Canva looked as a deal when the founders came to the Valley to fundraise – an Australian couple, no revenue, competing with Adobe, raising at $25Mn cap.
Uber had massive regulatory risks that most investors couldn’t get their heads around.
Almost every major VC has mentioned Pinterest as a big miss. It was totally unclear how Pinterest could be a “business”. Ben Silbermann talks here about “why every VC passed on Pinterest“.
As a venture investor, I think a lot about what mental models to use in order to spot these slot violations. Thinking through the earlier discussion with the portfolio founder, it was clear that even though investors might struggle to slot the company at this moment, the market was clearly resonating with the product. In a way, the early adopters in the market had been educated by the founder and therefore, were already bought into the “insight”, whereas the existing mental models of investors were lagging in their appreciation of this insight.
I call this “Insight Arbitrage” – the delta between the market’s and investors’ understanding of a startup’s unique insight. At the pre-seed stage, this market understanding will be mostly qualitative and anecdotal. At the seed stage, this understanding will still be likely on a very small base of users.
Because a majority of investors find it hard to build conviction in the above two scenarios, an Insight Arbitrage continues to perpetually exist in the venture world. And I believe that this is where an opportunity lies for investors like myself to generate alpha, provided we show the courage to trust this arbitrage and put our money behind it.
While the venture industry thrives on standard pattern recognition, outlier outcomes often lie in narrative violations of these patterns. But how does one spot these diamonds hiding in plain sight?
As I was analyzing some patterns in the kind of deals I was seeing over the last few months, something stood out. Most deals that I see tend to fall into 3 buckets:
#1 Clear “No” – it’s clear that there is a lack of mutual fit. Easy to move on.
#2 Clear “Yes” – I want to thump the table and invest. The bar for this is high and therefore, deals in this bucket would be max. 1-2 per quarter.
#3 Not sure – I like a few things about the opportunity but also see major question marks in other areas.
Bucket #1 accounts for the majority of any VC’s deal flow. A typical investor will evaluate hundreds of deals in a year and will invest only in a handful. So the VC job description itself is to reject at scale and anyone in the industry either already has or goes on to develop the mental capacity to do this.
Bucket #2 is a dream for any VC as these deals inspire high internal conviction in a very organic way. Though this conviction may or may not align with what other investors think, still one feels great about doing such deals as strong VC investors tend to be independent thinkers and follow their internal compass. If this conviction also aligns with other high-quality investors, then even better! Examples of this Bucket that I have seen in my career include Lenskart, Delhivery, and (I would like to believe) a majority of the Operators Studio portfolio.
Bucket #3 is what I call the “Middle Zone” of venture deals. In these opportunities, there are some things to intensely like and also a few question marks to temper these positives. Some personas of the Middle Zone from my recent deal flow include:
Strong founder going after a bad market.
A talented founder but weak founder-market fit.
A market with massive tailwinds, but weak founder-market fit.
A pedigreed founder who has just stepped out of a Big Tech, only with an idea and zero traction.
A very young (therefore, generalist) founder, often <2 years out of undergrad, with a limited track record and/or traction to diligence on.
A startup that has been around for a while and is now raising a bridge.
While I am not really “feeling” the opportunity, someone who I rate highly/ who understands the space deeply/ has spent a lot of time with the founders, and has high conviction/skin in the game.
As a venture investor, I am spending a lot of time thinking through the best way to identify & evaluate these Middle Zone deals. While the venture industry thrives on standard pattern recognition (repeat founders, domain expert founders, young generalists, ex-Stanford founders, co-investing with Tier 1 VCs etc.), outlier outcomes often lie in narrative violations of these patterns.
As an example, in my post ‘Three unicorns and a VC‘, I wrote about how Amagi was an unpolished diamond hiding in plain sight that most venture firms missed. I don’t want to miss the next Amagi that comes to me!
As accomplished angel & now VC investor Ben Narasin once said on a podcast:
There are deals we should do, there are deals we shouldn’t do, and then there are the ones in the middle. We make all our money in the middle ones.
-Ben Narasin
The fact that Middle Zone deals are non-obvious makes them less competitive and therefore, inefficiently priced, lending them well to giant outcomes when the bet turns out to be right. Hence, every VC investor worth its salt needs to have some mental models and heuristics in place to deal with them.
Here are some high-level guiding principles I have learned and am using for Middle Zone deals (more detailed heuristics are my secret sauce😉):
Middle Zone Case
Approach
Strong founder going after a bad market.
Mike Maples of Floodgate says (paraphrasing) – “A strong founder will ultimately pivot to a good market”.
My investing style is founder-first. So, strong founders going after supposedly bad markets are fair game for me. Though I would definitely try and ask – “If this founder is strong, why has she chosen this market to begin with?”
Also, I don’t find spending time on market sizing at the seed stage to be particularly beneficial. For why I believe this, check out my post ‘The TAM Fallacy At Seed Stage‘.
A talented founder but a weak founder-market fit.
If a founder is strong but the founder-market-fit is weak, I try and answer the question – “Can this market be won by first-principles thinking and hustle?”.
Many areas in Consumer Internet and Enterprise Software lend themselves well to young generalists, while areas like hardware can be excruciatingly painful to execute on and require a founder persona who is prepared for it.
A market with massive tailwinds, but weak founder-market fit.
This one is tricky. A working POV is that a “hot” market will get crowded very quickly and therefore, a founder without a clear right-to-win in it will struggle to build a large, enduring business.
A pedigreed founder who has just stepped out of a Big Tech, only with an idea and zero traction.
This case needs all art. Every context will be different but as an approach, important to understand: (1) Backstory of identifying the problem statement and leaving a cushy job to start up.
(2) Personal life story – motivations, adversities, aspirations, chip-on-shoulder.
A very young (therefore, generalist) founder, often <2 years out of undergrad, with a limited track record and/or traction to diligence on.
Again, this stage is all art. I like to look at 3 things here: (1) Does the founder fit a few “spiky” personas I like to back? A few I have written about before include storyteller vs scrapper and engineering dhandho. I would also include the college builder/hacker in it. A catch-all I like to use for these personas is born-to-be-founder.
(2) Does the market they are going after lend itself well to young generalists?
(3) Has the founder been able to acquire some early users/ customers that I can speak with?
A startup that has been around for a while and is now raising a bridge.
While I am not really “getting” the opportunity, someone who I rate highly/ who understands the space deeply/ has spent a lot of time with the founders, has high conviction/ skin-in-the-game in the opportunity
While I am not really “feeling” the opportunity, someone who I rate highly/ who understands the space deeply/ has spent a lot of time with the founders, and has high conviction/skin in the game.
This will vary a lot by context but as I said in my post ‘An Investing Framework to Find Startup Diamonds‘, one way of sourcing high-signal-non-consensus opportunities is (quoting the post): “a respected investor, sometimes a domain expert, has taken the time to evaluate & build high conviction around the company. Or a visionary customer is taking a bet, partnering with them in building the early product”.
While evaluating these signals, especially when they are from other investors, I find it useful to ask: “Is this deal amongst this investor’s best ideas?“.
I know that’s a lot to digest so let me give you the TLDR of what all the above analysis is trying to say:
Given Power Law, the most important thing in venture capital is getting into the companies with monster outcomes. Only the hits matter.
Based on history, many of these monster outcomes looked like weird companies in the beginning. Hence, having a strategy to sift these out of the Middle Zone is what gives a VC the Midas touch, and what at least I aspire for.
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In the words of the great Fred Wilson – “If you can’t figure out why you like an investment and why it will be successful, don’t make it”.
Recently, I came across this awesome (like always!) 2012 post from Fred Wilson (Union Square Ventures) – Social Proof Is Dangerous. Quoting a line that captures its essence:
If you can’t figure out why you like an investment and why it will be successful, don’t make it.
One of the big investing ideas I have distilled from studying the best investors across asset classes – from Charlie Munger and Howard Marks to Bruce Flatt and Vinod Khosla, is that to outperform the average (the index), one has to be “non-consensus-and-right”.
In fact, in my July’23 post ‘An Investing Framework To Find Startup Diamonds‘, I outlined a Consensus vs Signal 2×2 and argued that the outlier venture returns opportunities tend to be found in the High-Signal-Non-Consensus quadrant.
It was only in 2022, almost a decade after I first started my career as an institutional VC, that I truly embarked on this journey of trying to become a non-consensus-and-right venture investor. As I have outlined in the above 2×2, molding my mindset toward this approach has required consciously working on the following 2 elements:
1/ Having a unique world-view and trusting my instincts to be able to spot ‘Signal’.
2/ Totally ignoring any social proof noise while doing this.
I have observed that while it was really hard to ignore social proof early on in my career (eg. which VC is leading the deal), having seen so many Tier 1 VCs across geos do such foolish things over a decade, I must say with much humility that as of today, I find it much easier to ignore their POVs on something.
A few months back, I also came across comprehensive LP data that validates this organic learning. David Clark of VenCap shared with Jason Calacanis how loss ratios are surprisingly similar across various percentiles of funds, and even the best strike out a lot.
That’s why in my view, it’s foolish to do one-off deals purely on the basis of the social proofing of a lead investor in that deal unless one is actually replicating their entire portfolio construction (which is a benefit only LPs in their Funds get).
This idea also explains why I remain skeptical of loose angel networks, angel communities, and syndicates that really don’t have a unique, grounds-up world-view and right-to-win, and therefore in most cases, do spray-and-pray on allocations in deals being done by VCs.
These deals often suffer from major adverse selection (“if the founder/ startup is so good, why are they raising from you?” OR “what specific value are you bringing to the table because of which a star founder is giving you allocation?”) and are therefore, likely to be on the wrong side of the loss ratios of major funds.
Coming back to the point of social proof, let me neatly summarize my POV on it:
If the best Tier 1 VCs are striking out as much as an average Joe VC, there is no value in blindly following them.
There could be value in investing in the “best” companies of a Tier 1 VC portfolio but especially at the seed stage, it’s impossible to know beforehand which company will turn out to be this “best” company. Also, companies keep going in and out (and back in) of this “best” bucket multiple times anyway during a Fund’s 10-year lifecycle.
Even if there was a way to know which company isindeed the best company in a Tier 1 VC portfolio, why would they give me allocation in it? The best VCs want to keep every bps of ownership in their best companies only for themselves.
Hence, what’s the point of doing a deal purely because of social proof? I would rather spend that effort looking for the best contrarian deals in places where no one is looking, doing the work (and trusting my instincts) to spot Signal in them, and investing in them as early as possible, driven only by my strongest conviction and nothing else.
This approach is already starting to reflect in the early Operators Studio Fund 1 portfolio. In a majority of recent investments (eg. Soulside, Confido, Loop, Astrophel Aerospace, and a recent one in Stealth), I was literally the first investor to build conviction and say “yes” even before the round started coming together with other VCs. In several of these deals, I ended up catalyzing the round itself, making intros to eventual lead investors and even sharing my customer diligence notes with VCs evaluating the company.
In a way, this approach is Anti-Social proof and Pro-Signal. What is Signal, you ask? It can be of two types, as I explained in my July’23 Investing Framework post (quoting from it here):
Internal – extraordinary founder-market fit eg. the founder has spent a decade just going deep in the field. Or a backstory that provides an authentic “why” behind pursuing this idea. Or an execution track record in the startup’s arc that is outstanding on important elements like capital efficiency, iteration velocity, or organic customer acquisition.
External – eg. a visionary customer is taking a bet, partnering with them in building the early product. Or a domain expert, skilled operator, perhaps even a specific GP in a venture firm, has taken the time to evaluate & build high conviction in the company.
As you can see, there is a little bit of social proofing baked into evaluating Signal too, but it’s much more oriented around operating and execution-oriented conviction vs deal FOMO and an investing herd mindset.
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My notes from attending Camp Hustle, a unique LP-GP gathering. Includes actionable tips for those raising Funds 1 and 2.
It was a great experience to attend Camp Hustle last week. I have been following the work of Elizabeth Yin (co-founder of Hustle Fund, a pre-seed fund that organized this event) on X for some time now. All this while, I kept seeing posts from the last 2 editions of the event.
This time, I was in town, in a relationship-building zone, and looking to add new and interesting LP-GP folks to my community. So, I landed up at the event (who would say no to spending 2.5 days in the idyllic surroundings of Los Gatos and Saratoga anyway!).
Honestly, I didn’t arrive with a specific agenda or expectations from the event. I just went in with an open mind and knowing the vibe of the Hustle Fund team, I instinctively knew this would likely be the best frame of mind for this gathering.
The event turned out to be a pleasant surprise. Now I know why the name has the word “Camp” in it – the entire event had an informal, outdoorsy, campy, yet energetic and authentic vibe to it. Everyone agreed to an informal social contract – no explicit pitching, no so-called networking and no shallow talk. Everyone bought into the idea of just getting to know a bunch of folks and really bringing their whole, authentic selves to the event.
While the free-flowing, candid conversations amidst nature were the highlight of the event, I did end up with some really actionable insights shared by the Hustle Fund team, other emerging managers as well as a few LPs. Sharing my notes below:
While interacting with potential LPs, focus on making them a “fan” of the fund first. That is the first step towards eventually converting to an LP.
One common mistake during fundraising as a first-time manager is chasing people too aggressively. The key is to put out your story and let people come to you.
A great way to engage potential LPs is to send out a monthly/ quarterly newsletter. Also, Virginie mentioned doing informal LP meets in the Spring and Fall, so folks stay connected with the fund.
The majority of potential LPs you meet today might eventually invest in Funds 2 and 3. So, it’s important to start building relationships from now.
I asked Charles a question on ways to increase conversion on warm intros that a GP gets via existing LPs. While intuitively one might expect a healthy conversion on this type of lead, Charles confirmed that in his fundraising experience, the conversion on these referrals was indeed lower than expected.
2/ Venture investing learnings from the Hustle Fund team
During an informal AMA, Hustle Fund co-founders Elizabeth, Eric, and Shiyan shared the following top venture investing learnings from their anti-portfolio:
Always bet on your friends.
Don’t penny-pinch on valuation (they passed on an initial round of one of the largest consumer Internet outcomes because of valuation).
“Good deals have legs” – when you like a founder, push as hard as possible to get into the deal. Don’t be afraid of being perceived as a pain, if it can help you get into the deal.
Don’t over-index on what a market or company looks like right now. Learn to imagine what the market or a company can become “over a period of time”.
3/ Tips from an institutional LP
Courtney McCrea (Co-founder of Recast Capital) is one of the most experienced institutional LPs out there. In a candid Bonfire Session, she shared some insightful tips for emerging managers:
During an LP pitch, don’t be afraid to talk about how great you are. In fact, spend the first 3 minutes in a pitch just talking about your unique superpowers.
If you are having trouble creating a unique narrative for why your fund is different, ask your portfolio founders why they picked you and how they would pitch you to their friends.
LPs look at who you co-invest with and who does follow-ons in your companies, as signals for the quality of your deal flow.
There are so many LPs out there who aren’t pitched very often. Try and focus on them to improve your odds. Don’t underestimate the amount of capital that is out there looking to be deployed.
4/ Other helpful convos
Matthew Stotts of Cerulean Ventures shared that outlining the 10-year vision and story of what the fund is looking to do, goes a long way in generating excitement as most LPs are looking not just for financial returns but also for impact in whatever their personal mission is.
To re-engage with potential LPs in your funnel, try going back to them when you have an interesting development or story to share from the portfolio (eg. “we invested in Company X at the pre-seed stage and now, 12 months later, they just cracked a $XMn ACV deal”). This could also be done with a new differentiated investment or interesting deal flow.
[Via Rahul Vohra, Founder and CEO of Superhuman] One of the best pieces of advice Rahul got while building Rapportive was to pick a strategy to go from Point A to Point B, never change your mind about it, and continue relentlessly executing it. The goal could be say reaching 1Mn users, $100k MRR, or any other metric. The key is to stick with it.
Hope these notes help emerging managers out there. Once again, thanks so much Team Hustle Fund for creating this unique event format. Am excited for the next one!
PS: For those in SE Asia, the next Camp Hustle is in Bali in September🏖️
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The imagination of the best founders will kill any TAM analysis. Rather than over-fixating on market size, I suggest a couple of other elements that are more useful for evaluation at the seed stage.
As a freshly minted VC in 2011, one of the first things I was taught to look for while evaluating new deals was a large total addressable market (TAM). It was pretty much a necessary, though not sufficient, condition for generating outlier venture returns.
After many years of venture investing now, I would agree that startups need to go after large markets to be VC-fundable. However, I have also seen a common VC fallacy, especially at the seed stage, where a startup gets prematurely filtered out simply because the immediately visible market doesn’t seem large enough.
In my experience, the best founders either create new markets or expand to adjacent markets over time. So the TAM keeps growing. I remember when Peyush Bansal of Lenskart (the Warby Parker of India) was pitching for Series A, investors thought that the Indian eyewear market wasn’t large enough. In hindsight, everyone underestimated 3 things: (1) the overall market would grow at a much faster rate than expected, (2) in addition to online, Lenskart would also go offline and (3) it would expand the market by launching private labels, as well as increase its gross margins by in-house manufacturing. Lenskart’s last valuation: $4.5Bn!
Same with FirstCry, where most investors viewed the TAM as mostly Diapers because that was the majority of its GMV in the early stages. FirstCry is IPO-bound, likely at $3-4Bn valuation!
In the enterprise space, I remember Amagi’s initial flagship offering was the ability to insert vernacular TV ads in national programming. Investors pretty much checked out when they sized up this niche. What they underestimated was Amagi’s ability to go global, expand its product offering to an end-to-end cloud platform, and serve the rising OTT market. Amagi’s last valuation: $1.4Bn!
The entire thread is super-insightful, wherein PG is repeatedly trying to explain to Fred that the eventual market will include hotel accommodations and therefore, will be large enough.
In fact, one of the strategies that is highly recommended for seed-stage startups is to identify a wedge in the market, usually a very sharp pain point or job-to-be-done, and focus on solving that in a differentiated way. By definition, these early wedges often create an illusion that the addressable market is limited to just that.
This is where the role of imagination comes in. Seed investors should spend adequate time with the founders to understand the eventual end-state of the world they are imagining. If this end-state is large enough and ambitious enough, usually that’s a leading signal that the company will continue to expand its TAM.
Turning the tables around, I also believe that founders should spend time crafting a strong narrative around this end-state and paint a picture that investors find easier to buy into. If this can include even a broad outline of what the path from the present wedge to the eventual end-state potentially looks like, even better.
I hesitate to call this picture a “vision” as this word is just thrown around a lot and frankly, is now considered faff. Instead, trying to visualize what the world will look like with your product in it, is much more tangible and real.
So, if not TAM, what aspects should seed investors evaluate instead? I recommend the following two:
1/ Founder-market fit – this is critical for the startup to go from the wedge to the end-state, and should be in place even at the earliest stages of company building.
2/ Competitive differentiation/ right to win – as I mentioned in my post ‘How To Differentiate As An AI Applications Startup?‘, for a startup to be viable, it’s not enough to just build cool tech. It has to be able to create significant competitive differentiation, especially against incumbent solutions. I call it “non-incrementality”.
A strong hypothesis around competitive differentiation, and eventual right to win, should exist in the founders’ strategy from Day 0. The edge will get gradually built out over time, but both the intent to create it as well as the building blocks for it need to exist from the earliest stages.
Looking back on the many startups I have seen or invested in across geographies, one thing I have learned is that if a startup remains sub-scale, in most cases it tends to be due to founder motivation, quality of execution, and team/culture issues, rather than the available market being small.
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Outlier venture performance requires being non-consensus-and-right. Framing your role as a Talent Scout, vs. just a Picker, improves the odds of finding such opportunities.
I strongly believe in Howard Marks’ framework that for better than average investing performance (i.e. beating the benchmark), an investor needs to be non-consensus-and-right. My own derivative framework for venture investing is to look for High-Signal-Non-Consensus deals – companies where I am catching strong leading signals, but which the investor-crowd is struggling to understand.
Executing this strategy well requires consciously looking for:
(1) Overlooked markets, and/ or;
(2) Underestimated founders.
If both the market and team were hot, the company by definition, would be consensus. Consensus deals get significantly bid up in price, and as Howard Marks frequently says, high prices indicate low future returns. Therefore, through both learning from OGs like Howard Marks and observing my portfolio’s behavior over the last decade, I have gradually come to believe that entry price definitely matters in venture investing.
While evaluating teams, the role of a VC is often defined as that of a Picker. The best GPs possess a combination of 3 abilities:
1/ Analyzing tangible skills for founder-market fit.
2/ Using past experiences to pattern-match for intangibles like grit.
3/ Having a 3rd filter of intuitive judgment that may override the previous two.
While these features are cool for venture capital in general, they might still fail during the specific quest for identifying underestimated founders. By definition, many of these founders don’t have classic indicators of tangible skills such as Ivy League backgrounds, Big Tech work experience etc. Further, they can have quirky, irreverent, or misfit personalities, so pattern-matching with past venture-backable personas will also not give the right output.
The 3rd feature of intuitive judgment becomes overwhelmingly important in this scenario. Therefore, to describe a venture investor who is on a conscious quest to discover underestimated founders, I prefer the framing of a ‘Talent Scout’ over that of a Picker.
To highlight the mindset of a Scout, here’s a cricketing story once shared by the famous Pakistani bowler Shoaib Akhtar, the fastest in the world at that time who regularly hit the 150-160 kmph range. As an unknown player harboring ambitions of playing for the national team, Shoaib once turned up for trials that were being run by legendary cricketer Zaheer Abbas. More than 3,000 kids turned up so to grab Mr. Abbas’s attention, Shoaib started running laps around the 3 km cricket ground in sweltering heat. A kid hungry enough to be doing this madness caught the legend’s eyes. He asked Shoaib to bowl one ball at the nets, and the rest is history!
The mindset of a Talent Scout is to focus on developing a ‘Feel’ for talent, judge how strong this Feel truly is, and then have the courage to let it become the basis of strong conviction even in the absence of other tangible signals. What’s the source of this Feel, you ask? That’s the alpha, the x-factor of the Scout. Sometimes it’s a unique worldview of what it takes to win in that particular game. It can also be just a superior reading of human behavior. Often, Scouts can access a subconscious intelligence, built up over many years but still hard to precisely explain.
When meeting non-consensus founder talent, I have found adopting the mindset of a Scout to be immensely helpful. It’s a very different context from evaluating a typical venture-backable persona or a relatively proven team, and therefore, this change in mindset leads to an interaction of a very different flavor.
The hope is that having a talent scout mindset leads to an increased likelihood of non-consensus-and-right investments, thus positioning the portfolio for generating venture alpha.
Closing out with this line from my friend Manish Singhal who runs the deeptech fund Pi Ventures – “We don’t have proprietary deals. We create a proprietary view on the same deals everyone sees.”
PS: if you liked the concept of scouting underestimated founders, do check out my post ‘Reputations and Underdogs in VC‘ which tackles whether spending time with the laggards in your venture portfolio makes sense or not.
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As a fundraising founder swimming in the rough seas of skeptical investors, sometimes all you need is a high-conviction intro from one sponsor to tip the scales in your favor.
As a venture investor, referrals from people in my network is one of my top channels of deal flow. There are hundreds of startups that reach out for fundraising discussions every month. Having someone you know vouch for a founder automatically gives initial comfort around taking a meeting.
Over the years, I have observed that these referrals fall into 3 categories:
1/ Weak intro: beyond being a friend, the referring person doesn’t know much about the founder’s idea or the reasons behind pursuing it. These referrers are usually the founder’s weak acquaintances and are only helping out with connecting to a bunch of investors.
While even a weak intro ensures that I pay attention to the startup, conversion to a live interaction is usually low.
2/ Warm intro: the referrer has deeply known or worked with the founder in the past, and has a fair idea about their personal mission, goals, and personality. Typically, these referrers are ex-direct managers, peers, college friends who have stayed in touch, and other direct collaborators. They might or might not have an understanding or appreciation of that particular startup idea but believe in the founder.
These intros are solid, especially as the founding team is the top-most investing criterion at the early stages. In most cases, I will typically schedule a 30 min. video call with the founder at the very least.
3/ Conviction intro: the referrer has spent significant time either organically or consciously, to develop a deep conviction in both the founder and the startup idea. These referrers are usually founder execs, senior operators, angels, and VCs.
In the best cases, the referrer is also showing skin-in-the-game via either investing significant money and/ or time in the startup.
Conviction intros are gold and a great signal of the quality of an investor’s deal sourcing. For almost all such intros, I end up scheduling a 1-2 hour deep brainstorming session to get into the weeds. Interestingly, by the end of these sessions, the judgment on whether to invest or not gets immediate clarity.
Adding more nuance…
I would like to go one level deeper on Conviction Intros, and talk about what I call ‘One Person’s Conviction Intro’.
Those who regularly read my blog would remember the post ‘An Investing Framework to Find Startup Diamonds‘. In it, I talk about the ‘High-Signal-Non-Consensus’ quadrant where the best startups are to be found at the early stages.
(4) High-Signal-Non-Consensus – these are the opportunities we as venture investors live for. They are highly non-consensus, with the investor-crowd struggling to access, understand, evaluate risk and build a positive view on them. Yet, these startups have high-quality leading signals, which could be external and/ or internal.
External – eg. a respected investor, sometimes a domain expert, has taken the time to evaluate & build high conviction around the company. Or a visionary customer is taking a bet, partnering with them in building the early product.
Internal – extraordinary founder-market fit eg. the founder has spent a decade just going deep in the field. Or a backstory that provides an authentic “why” behind pursuing this idea. Or an execution track record in the startup’s arc that is outstanding on important elements like capital-efficiency, iteration velocity or organic customer acquisition.
This quadrant is the hardest to source for and requires having a really differentiated network of relationships (for referrals) and a personal brand that attracts interest from these types of founders.
As mentioned in this excerpt, the High-Signal part comes from someone credible putting in the effort to build conviction, demonstrating skin in the game via committing any type of valuable currency, and then risking their personal reputation to socialize the opportunity with their trusted networks.
This opportunity might still be Non-Consensus, with the investor-crowd struggling to appreciate it. Yet, this referrer (or perhaps ‘sponsor’ is a better word in this context) is willing to be contrarian and follow their own conviction built from first principles.
When this sponsor refers a deal to me, this One Person’s Conviction Intro sits at the peak within the universe of Conviction Intros, simply because it has a high likelihood of being a key to the High-Signal-Non-Consensus quadrant.
However, even an investor with the highest quality deal flow can only expect a handful of such intros every year. The reason is most founder execs and operators don’t have the time and/ or incentives to build independent conviction. And most angels and VCs tend to demonstrate herd behavior, preferring to lazily piggyback on the conviction of others versus taking the time to do independent thinking.
So, even though my investing style is predicated on searching for these intros, the world is supply-constrained with respect to them. However, what I can do is swing really hard when I do get a few of these fat pitches every year, and maintain discipline at all other times. Venture investing is a very forgiving game where one isn’t reprimanded much for the losers, as long as you get a few right in a big way!
For founders, getting warm intros to investors has now become common knowledge, and frankly, table stakes. However, what could give you an edge over hundreds of other fundraising founders is inculcating that one sponsor – someone who can build independent conviction on your yet-unvalidated startup, show skin in the game, and socialize their commitment to other investors.
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While public markets appear to be decisively reviving this year, venture activity barring AI is still very slow at large.
With founders & investors worried about when the good times will return, I turned to an age-old framework by the OG Sir John Templeton to try and answer this question.
In this pod, Bill cited an insightful quote by the late Sir John Templeton, the legendary founder of Templeton Funds:
Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.
Sir John Templeton
A. Templeton’s framework
Bill then goes on to apply this Templeton’s framework to explain market cycles over the last 15 years as follows:
During this period, the first point of maximum pessimism was in March 2009, which then birthed a new bull market. The next point of max pessimism was March 2020, which gave rise to another bull market.
Dec 2020 was the point of optimism, post which the market fell ~38% but then rallied again. Ultimately, the point of euphoria was reached in Nov 2021, which saw the peak of popularity for innovation bulls like Cathie Wood of Ark Invest. At this time, interest rates were at rock bottom while valuations of unprofitable growth companies were sky-high.
The most recent point of max pessimism was in the Fall of 2022. Since then, overlaying market performance on top of Templeton’s framework, it’s safe to say that the next bull market has already started. Markets are up ~20% since this last point of max pessimism and therefore, this new bull run appears to have reached the “grow on skepticism” phase in July 2023.
Bill then goes on to say something super insightful (man, the amount of wisdom in this 10 min monologue!). Paraphrasing a bit here:
Microstrategists try to use their view of the economy to determine where the market is going. And that’s exactly backwards.
The economy doesn’t predict the market. The market predicts the economy.
The market comprises of real people with real money at risk, and the totality of them is how the market acts.
Bill Miller
Just think about the 2nd para in the above quote. It’s an amazing thought! Intuitively, we all tend to think of the market as an analytical engine when in fact, it’s actually a prediction engine. It’s a complex system where hundreds of millions of people are looking at all the info they have, making a prediction of where the economy is likely to be headed & placing bets with real money based on this prediction.
But I digress! Coming back to Templeton’s framework, as I was digesting it in the context of public markets, I ran a thought experiment on whether it applies to the venture market as well. This is how the exercise went.
B. Applying Templeton’s framework to venture
It’s important to mention upfront that private markets differ from public markets in a few important ways, which manifest in specific behavioral characteristics:
1/ They are illiquid ➡ price discovery happens gradually & therefore, lags public markets at least by a few months if not years, due to system inertia.
2/ They have fewer (very small retail participation) but more sophisticated participants ➡ both upward & downward resets have relatively less internal momentum & are, therefore, more gradual.
3/ They have high information asymmetry ➡ takes time to gather, analyze & react to information. Given higher imperfections, probabilities & confidence intervals are assigned to conclusions more conservatively.
4/ There is negligible automated trading & auto-pilot inflows ➡ information is analyzed & acted on by real humans in a slower, more deliberate way.
Essentially, private markets are slower, more concentrated & more deliberate with longer feedback loops than public markets. Therefore, while public markets can be analyzed daily, weekly, or monthly, I believe a safe unit of time to analyze the cyclicality of private markets is a year.
To start applying Templeton’s framework to the US venture market, I looked at data for total venture capital $$ invested in the US every year since the dot-com bubble. Here’s how the data looks:
Source: NVCA Yearbooks(for years marked with *, data was sourced via ChatGPT as it was unavailable on the NVCA website)
Here are some insights I gathered from this data:
1/ During the dot-com bubble, 1997 and 1998 look like the years when the venture bull run entered the “grow-on-skepticism” phase. It then hit the “mature-on-optimism” phase in 1999, achieving the “point-of-euphoria” in 2000.
As per the Templeton framework, the point of euphoria is when the bull market typically starts its journey toward death. This is exactly what happened to the dot-com bull run between 2001 and 2003, hitting the point of maximum pessimism in 2003. Interestingly, going back to the earlier point of a lag between public and private markets, this 2003 point of max pessimism for US venture was a year behind the same for public markets (they bottomed in Oct 2002 when the S&P500 hit a 5 and a 1/2 year low).
2/ Moving forward, the US venture market again followed Templeton’s argument of “bull markets are born in pessimism”. The seeds of its next bull run were sowed in 2003, subsequently entering grow-on-skepticism during 2004 and 2005. This bull run entered mature-on-optimism in 2006 and 2007, growing 25%+ y-o-y.
But before it could hit a real point of euphoria, the housing crisis happened in 2008. The US venture market hit the point of max pessimism in 2009, and similar to the dot-com run, lagged the public markets by a year (their point of max pessimism was in Sep 2008).
3/ With the tailwinds of the Fed’s zero interest rate policy post the ’08 crash, the US venture market saw a secular bull run between 2010 and 2021. Barring a few corrections and a brief Covid hiatus, this was an almost uninterrupted, decade-long, dream bull run.
Fueled by massive liquidity injection by the Fed to counter potential Covid-driven economic distress, on top of astonishingly low levels of interest rates, the US venture market hit the point of euphoria in 2021. As I wrote in my post “Making Hay During Market Peaks“, this was the year of “Crypto shitcoins, ape NFTs, meme stocks, IPOs of unbaked tech companies, and real estate boom in as far as Denver & Raleigh”.
C. Where are we now in the current venture cycle?
Consistent with Templeton’s framework, the recent decade-long venture bull run started its downward spiral from the point of euphoria in 2021 and subsequently hit a point of max pessimism in 2022 (~30% y-o-y decline in VC $$ invested).
But this framework also tells us that the seeds of the next venture bull run were also sown simultaneously at this point of max pessimism in 2022.
As we stand today, I get the feeling that the US venture market is close to entering the Day 0 of the grow-on-skepticism phase of its next bull run (I wrote about how the excesses of 2021 are now winding down in my post “Cheetah in the Rainforest: 2021 Vintage of Venture“).
Per Bill Miller, public markets have already entered the grow-on-skepticism phase decisively, showing ~10% gains in H1 2023, and are likely to continue on this trend in H2. Assuming a ~1-year lag between public & private markets like in previous cycles, my expectation is that the next venture market bull run will decisively enter the grow-on-skepticism phase in 2024.
C. Closing thoughts
As a disciple of Charlie Munger, while I don’t believe in macro forecasts (especially by economists & equity research analysts), I am also a disciple of Howard Marks and therefore, a strong believer in the importance of studying market cycles across asset classes. Where we are in a cycle should be one of the important inputs for deliberation on an optimal investment stance, including what mix of offense & defense to aim for.
Hence, my fascination with Templeton’s framework, and how well it works as a tool for studying cyclicality in both public & private markets.
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