Time for a return to classical investment wisdom
[Written as an epistle to Vasco Patrício]
I take a long time horizon approach to investment myself. I observe that it is rather difficult to make decent money with a VC fund.
This is particularly the case outside of the Silicon Valley tech-capital focal point. It is harder to find the most interesting companies, and harder to get large, fast money to go big quick, chasing huge multiples.
In recent years, megafunds have been raised whereby a single fund can fully-fund an entire venture all by itself, locking out all other investors. This means that the best startups will always go to the biggest funds (and stay exclusive to them), making it even harder for smaller players to find good deals.
Even clinching a good deal on a great company is no guarantee. Not every unicorn pays off in generating shareholder value, even if it’s a household name. High-growth low-profit tech companies may be due for a reckoning soon. Meanwhile, many profitable ventures are overlooked because they don’t make sense from the traditional unicorn-hunting high-growth methods and mindset.
Many excellent firms have their follow-on funding pulled simply because the market needs time to mature until they can cross the chasm, and the VC needs to close the fund. All of that technology, carefully nurtured team, and a great culture ends up wasted, or acqui-hired for a pittance, whilst the staff ‘phone it in’ until they can vest and escape.
Also, a lot of VC funds may not have enough ‘dry powder’ for follow-on due a lack of liquidity, even if they wished to invest.
Both of these problems create a drag on the economy, and wastes the best years of hundreds of people’s lives, on a great goose chase that rarely makes much past breakeven. But management fees get paid, and some money usually returns to LPs eventually, so no-one is too heartbroken (except the founders). Such is the consensus way of doing VC, with the perverse incentives that cause it to underperform.
I advocate for different tactic in managing investments: Two streams – Fast and Slow.
Fast Stream – This is similar to traditional VC, looking for fast-growing companies that can multiply their value quickly, but with more patience than usual for market development, if it makes commercial sense. This is possible due to not having a fixed cash-out return date, due to increased liquidity as a blockchain-based fund, the transparent NAV/Market Cap, and thus a potential to be open/evergreen. This seems like an attractive proposition to potential startups.
Slow Stream – A revenue share, dividend, or convertible loan based construction (or combination) that enables profitable yet modest ventures to tick along and pay back smaller returns on a long time horizon. There is a demand in the market for lower-rate lower-risk instruments, as investors struggle to put money somewhere that can beat inflation whilst also appearing fairly safe from a crash.
Certain fizzling ventures might move the fast stream to the slow stream if their capital needs and growth rates are less than expected, or potentially even the opposite direction.
A fund which adopts such an approach can be much more flexible, able to cope with a range of eventualities, and to make greater, sustainable returns over a longer period. Management may enter or retire from the fund as required, and the tokenized nature of the fund enables transparent incentive structures that can be built-in, increasing the opportunities for investment or dealflow incentives, whilst also potentially reducing administration.
Management of many small concerns traditionally takes too much management bandwidth to be worth it. However, by requiring that they complete low-touch business dashboards and mandatory monthly reporting, which could be directly outputted for corporate reporting requirements.
This also helps to provide an early-warning system of a particularly troubled or promising investment (where an intervention may be warranted), and to help ventures to keep on track. It should be minimally taxing in terms of time and attention for entrepreneurs, and also should include paper trails to ensure honesty and compliance.
Such an approach enables a portfolio of fast and slow successes, and gives confidence to founders that they will get support if and when they really need it, and forbearance if they do not.
I happen to come across many promising ventures in my travels, and I take the opportunity to have a brief discussion with the founders (and ideally also the engineers) where possible. Even if a venture may not be at the right stage or scale for investment, if I like the talent involved in the venture I will want to know more.
From time to time I will discover an unmet need and posit a way to fix it, and then I will explore ventures in that space to see if any are already worthy of investment or might have some IP of value.
I have enough awareness of various tech domains to perform a lot of DD myself. I find it easy enough to know what has substance and feasibility, and what is merely a paper tiger. If it’s some deep blockchain or biotech, then I would be inclined to bring a specialist onboard for a second opinion and a review of code and methods.
I tend to delegate the day-to-day follow-up on progress and growth to trusted associates, only stepping in where a critical branching decision on the expected value of the venture in the future has arisen.
I think it’s important to demonstrate clear value to founders. Many will assume that investors are full of hot air, or will clumsily try to influence things where not required. I try to demonstrate this in three main areas:
Technical knowledge – Understand enough of what they are doing to be able to meaningfully model it, and to describe where it is strong, and where it is weaker.
Wu Wei approach – Only you know how your own shoes pinch. An outside perspective can be helpful to spot potential pitfalls or missed opportunities, but only those in the trenches can understand the situation. Back the founder up, put faith and trust in them to know what’s best, and try not to meddle.
Character Study – Make observations on where the founder is weaker, and encourage them to de-risk those with extra resources, or potentially a voluntary shift in roles. Show that you understand the types of areas that they excel in, and encourage them to flex those strengths.
Everything flows forward from people. Keeping them happy, healthy, and productive is crucial. Executive coaches can be very helpful for accelerating a relatively inexperienced founder in a professional sense. However, I often find that simply providing kindly, pastoral care is more helpful. It can be difficult as an investor however, due to the mixing of roles. It’s sometimes easiest to mentor and provide guidance for founders who one isn’t directly involved with, with a quid pro quo of care for one’s own charges being given by a trusted peer.
If one has honestly gained the trust of founders, it is much easier to guide them, or to find a compromise that everyone can live with. I would always try to have an informal discussion before making something formal and explicit. I also try to understand the reasoning of the founders, why they themselves believe that a certain approach is the best way. It’s crucial to make sure that one has all of the relevant information and is acting upon solid assumptions.
In the case of an irreconcilable conflict I would try to bring in a peer founder in an unrelated venture to help to bridge understanding. If a CEO is truly being unreasonable, then they are more likely to recognise them from a peer than with someone whom they may consider to as being a quasi-adversarial relationship.
Given my scepticism of the value-add of most early stage venture capital, I would tend to emphasise an angle or model that has been designed to align incentives in a more productive manner, with less ravenous demand for unsustainable growth and ruthless efficiency, and an emphasis on creating genuine long term value, both for investors and society at large. This is particularly the case given the market volatility at present, and an inevitable reckoning.
In my view, a model that better reflects traditional investment wisdom from before the 1980s, updated through new methods, combined with a solid team, should be a highly investable proposition at any time.
In short:
Before bringing out the big guns, bring out other founders. Using a founder of another startup to come in and help mediate a situation with a portfolio founder can be a good strategy. Being a lonely profession, founders are not understood by many people – but other founders are someone that fully understand their journey and point of view.
Structured reports help save time. As a GP, it’s possible you will be spending a lot of time with trivial matters with the founders. If you have a dashboard and/or periodic reports where founders can convey the company’s KPIs, you will have a bird’s-eye view and not have to waste time with the small stuff.
As a board member, add value in very specific areas. I focus on technical knowledge, de-biasing the founder’s perspective and assessing their personality/strengths and weaknesses. As a board member, know exactly where you can add value and intervene there.
Rules for Investing, especially now:
It’s generally easier to see potential deal breakers at first glance, before one does any further analyses. Below are the instant turn offs that would cause me to not want to invest in a venture, even if it looked good on paper. These are the kinds of companies that have fundamental weaknesses likely to kill them in the long term.
Bet against companies that treat their customers with contempt, try to cheat them, or routinely make them miserable.
Bet against companies that are overly predatory or cut throat in their business dealings.
Bet against companies that have ever made stock buybacks or similar financial chicanery.
Bet against companies overly invested in short term gains or their quarterly reports.
Bet against companies that are ‘high geared’ with leverage and other debts.
Bet against companies that don’t appear to mitigate systemic risk.
Bet against companies that don’t know or care about their negative externalities.
Bet against companies with poor epistemology, or which promote questionable ideas without good reference.
Bet against companies pandering to ideology.
Bet against companies that treat their staff as thralls.
Once these kinds of companies are removed from the selection basket, picking the probable mid to long term winners gets a lot easier.
The same general rules can be applied to nations also.