As Peter Thiel puts it in his book “Zero to One” nobody is looking for toilet paper that uses 1 leaf instead of two, VCs would be attracted by a whole new concept a whole new way to “do it”. The reason behind this behavior from investors, especially Venture Capitalists, is exactly that, the lack of Venture on traditional Businesses. In this article the reasons for this behavior are backed up with different scenarios and reasons to them.
Power Law Returns Economics
The idea of the power Law is that a tiny number of the investments performed will bring the majority of the returns. This means, many of the investments will only cover the initial capital, or even lose some of it. While only a few of them will bring 10x – 100x in returns. It is important that at the initial assessment, all of them seem to be able to bring such return under the right conditions and management.
VCs are looking for the next big thing
As Mahendra Ramsinghani puts it in “the business of venture capital”, Venture Capitalism is about finding the next big thing and embracing risk. Venturers thrive on disruption, looking for the technology that can change the world. This can be seen as a chicken-and-egg kind of situation, since while one reason is the risk attractiveness, on the other hand there is the pressure from LPs to VCs on finding a quick return on their investments. Such quick returns cannot be achieved with conservative safe companies.
Fund Structure and Pressure from LPs
Depending on how the VC’s Fund is structured they may receive pressure from the LPs. The source of such pressure can be external and internal. The degree of such pressure is related to the way the Funds are structured. Examples of structures are:
- Traditional Institutional VC Fund- High Risk, High Return:
The highest of all the pressures is the one related to the institutional Fund. They operate with a “home run” strategy, willing to lose most of their deals at the expense of one or two 10x or 100x deals. - Corporate VC Fund – Strategic Fit:
The next down decreasing pressure is the one where the money is coming from a corporation. They typically prioritize a strategic fit, rather than a very big hit, and are willing to sacrifice returns for the long run cooperation and acquisition of strategic startups. - Evergreen/Family Office- Long term wealth impact:
The lowest pressure is applied by the family offices, which are looking into much longer horizons, with a lot of flexibility.
Risk is addictive
“The thrill isn’t in the reward; it’s in the risk.” This can be described as the other reason why VCs are so passionate about risk. “Heroes are heroes because they are heroic in behavior, not because they won or lost.” As Nassim Nicholas Taleb wrote in Fooled by Randomness. Everyone wants to be the hero of their LPs, finding that golden treasure, the Goose that lais golden eggs. Everyone at Venture Capitalism wants to have that prestige and with that, the probability of creating even bigger and riskier funds.
What can a founder do to be even considered by VCs?
It all starts with the vision. Envisioning a company that will only have a flat growth and remain profitable but with little profits is not attractive or investable for VCs, unless there is another reason that exceeds the pure business considerations (social or technological). Establishing as vision to be the biggest company in certain market could be powerful, but it needs to remain credible and in a market that is big enough to get VCs excited. It would be more difficult to explain and for VCs to believe that a company will beat Amazon and be the number one online retailer, than to be the biggest Carwash chain in the market, even though that is also very tough it is more credible and doable.
Good old diversifications
To not fall in love with the own business plan is probably one of the toughest but more helpful thing a founder can do to show flexibility at talking to investors. Investors (at least the good ones) are full of ideas and recommendations. 90% of them will not be applicable to the business model or simply garbage, but it is important to listen and consider all of those. Diversifying the risk for a founder, is about trying different approaches to be able to combine all those that work well, and discard the rest based on an own experience.
When Investors put a founder against the ropes, the vision must be big enough to justify the excitement, but that may not be enough to get them to invest, and a few concrete steps will help to be more prepared, mainly with a good Go-To-Market Strategy.
Multichannel G-To-Market strategy – Hire GTM Experts EARLY
A multichannel approach means that the product of service the startup/founder offers is arriving to the end user through different paths, all of them are understood and monitored by the startup itself. Controlling the Value Chain means to be in charge of the company’s own destiny.
Donald Trump said that the main 3 key principles about Real State investing is location, location, location.
The 3 key principles of GTM in VC Investing are Customers, Customers, Customers.
To realize an outside-in vision and make sure everything the organization does is envisioning customers’ needs requires a certain level of skill and experience. No one should expect the founder to have all those skills and experience, but experts are available in all verticals, and should be considered to accelerate the execution as early as possible.
