5 Secrets of Venture Capitalists

Since no one else wants to spill the beans, I will.

What’s interesting about coming from Private Equity and Family Office investing into Venture Capital is how similar the asset classes truly are. On the outside, people will tell you how wildly different these industries are, but I have found them to be much more similar than different.

Still, there are some things that are unique and semi-confidential to VC that I thought would be worth sharing to a wider audience. Consider this an insider’s look at the secrets that VCs (probably) don’t want you to know . . .

Secret 1 — Their experience is limited

This one is actually ubiquitous in finance. Everyone seems to tell some version of this same sentence:

“I have a bunch of experience. Give me money Mr. Investor and I will do it again!”

That’s what they tell their investors and what they pitch to startup founders they are trying to invest with.

What they won’t tell you is how that experience has a shelf life and becomes less relevant by the day. Think about this: If someone built and sold a startup twenty years ago, how relevant would that experience be to 2019? Ask them what their cloud strategy was and how they juggled pricing and products between Azure vs AWS vs Google?

What do you think they would say?

They didn’t deal with that. They didn’t deal with the recruiting pricing challenges of Silicon Valley in 2019.

That doesn’t mean their experience is irrelevant. It’s just not as relevant as they imply it is. As with most things, it ages poorly.

Similarly . . .

Secret 2 — Somehow, in VC, ONE is a trend

“Look, I built and sold one company! I can invest in dozens of companies and exit them just like I did that one time!”

You did it once?

If it rained only one day last week, would you say it was a rainy week?

If your friend won the lottery, would you say she has a tendency to win the lottery?

It baffles me that somehow a one-time event can translate into “I can do this a bunch more times!”

It’s Survivorship Bias at its best (worst?) and you’d be surprised how many successful entrepreneurs raise VC funds based off that exact logic.

It’s not that a successful exit is irrelevant. Far from it. It’s just that something (anything) that happened a single time is not a trend.

Secret 3 — They have much less autonomy than they imply

Every true fund has a Private Placement Memorandum (“PPM”). It’s a huge, 60–70-page document that lays out what the funds is, what it does, what it can’t do, and how it will do it.

As you can imagine, it’s chock full of legal language, clauses, obscure scenarios, and anything else you can imagine someone’s attorney would want if they were giving you tens of millions of dollars.

What happens with these PPMs is they end up narrowly defining the investment thesis of the fund. They basically say “Fund X can invest in startups at Stage Y that do A, B, or C and nothing else.”

The implication is that if the fund invested in “D”, they could get sued by their investors. Probably not a risk worth taking for most investors.

That’s why I mentioned before that most investors have relatively narrow investment theses and if you don’t fit, you’re probably out of luck with that particular investor.

Still, you won’t hear any VC touting how little leeway and autonomy they have over the capital in their account.

“Gee, Sally Startup, I’d love to invest in your company but I need 60 days to ask the permission of all of my investors to see if it’s ok.”

Does that sound like the VCs you know? Didn’t think so.

Secret 4 — There’s an unspoken class system

This is another VERY common characteristic in broader finance ecosystem. Everyone looks down on someone else. If you don’t work at Blackstone, you aren’t a big deal in PE. If you don’t work at Goldman, you are irrelevant in Investment Banking, right? It’s nonsense, but that’s the way the thinking goes.

It’s just Pedigree 3.0. Nothing new here, but the strata in VC are interesting.

The perceived top of the heap (Tier 1) is the blue-chip mega funds. Think Kleiner Perkins, Sequoia, Accel, NEA, etc. They manage billions, have been around for decades, and all invested in facebook and Uber. They seem to think that they see the only deals worth doing and everyone else is just in a race for the second best deals on the market. They might be right, but who knows?

Below that (Tier 2), you have the up-and-coming and niche funds. These guys have had some success, raised a few hundred million across a few funds, or built out a successful niche. Think of Obvious Ventures, Signal Fire, Correlation, Upfront, etc. They are great, have a track record, and seem to be narrowing the gap between themselves and the blue-bloods. They lead rounds, have great talent, and can raise capital (almost) at will. Softbank’s Vision Fund probably lives here for better or for worse.

Tier 3 is the micro-VCs and young funds. These are the guys who have actual, real funds with multiple LPs. They are testing a thesis, building a niche, and just starting to get off the ground. They might be onto something, but they might flame out. It’s too early to tell. Think Fifth Wall, Fool Ventures, Next Gen, etc. They have multiple investors, might have some early success, and will be lead investors.

Tier 4 is where the Franken-funds live. These are the CVCs, family offices, single-LP funds, Angel funds, and other non-traditional vehicles for investing. They have capital and do invest in startups but they really can’t/don’t/shouldn’t lead rounds and may not act like the top three tiers in terms of timing, diligence, feedback, or other aspects of the process.

Tier 5 is incubators and accelerators. Yes, they provide capital to startups, but the general sense I get from investors on incubators and accelerators is they use the spray-and-pray strategy of investing in startups. That is: “If we invest in 1,000 startups, the winners will win big enough to outweigh the losers.” That’s been the knock on even the best ones like Y Combinator. I’m not saying it’s true or false. I’m saying that it’s perceived that way.

There is your (perceived) VC caste system.

Secret 5 — They need you as much as you need them

If VCs don’t invest in rocket-ship companies, they won’t be VCs for very long.

They all claim proprietary deal flow and the ability to spot the next AirBnB. If you actually are the next AirBnB, your investors need you to be successful just as badly as you do.

They will act all thought-leadery.

They will prognosticate and give macroeconomic predictions. They even understand blockchain!

They will be hard to reach. They push you down to their 26-year-old analysts.

They will poke holes in your company, call your baby ugly, and generally harass you during due diligence.

But, at the end of the day, they need great companies to make their investors happy (see Secret 3).

They NEED great startups. That’s the job. If they don’t do that, there is no more venture fund.

Keep that in mind during negotiations, diligence, and investor scouting.

There you go. 5 secrets of venture capitalists. Tell me what I missed.

Know any other juicy secrets worth discussing?