“What industries are you interested in?”
This question has come up in almost every conversation I’ve ever had with a venture capitalist. An alternative version often asked is what trends I’m particularly excited about for the next ten years. If you watch interviews with VCs, the journalist or student will almost always ask a variant of these questions. It’s hardly surprising: it’s exciting and interesting to talk about the hot sector of the day and imagine its promise whether it’s crypto, edtech, or healthcare. VCs are expected to have theses about the future: the impetus behind their investment decisions.
As I mentioned before in a previous newsletter, my instinct when approaching something new is Deconstructive Thinking: starting at the most fundamental level before adding on multiple layers of complexity. With spelling, starting with root words creates a firm base for much of the dictionary. With geography, starting with the locations of countries forms a coherent mental map of the world. With poker, starting with heads-up is a great way to understand hand-reading in its most wide-ranging form.
In venture, some of the key buckets are judgment, dealflow, winning competitive deals, and a unfair personal advantage. The first area that I wanted to explore was judgment. In retrospect, I believe my love for poker and intuitive betting may have colored my interests. For someone who is a relative unknown in Silicon Valley, focusing on generating dealflow and building a network (even in COVID times!) may have been a superior first concentration. This is a mistake I’m hoping to rectify over the coming months.
To begin my venture education earlier this year, I started watching YouTube interviews and read the writing of some of the GOAT venture investors. Over the many hours, a funny pattern emerged.
Every time one of them was asked about “industries” or “trends” they were excited about, they would invariably recoil.
“I don’t invest in trends---you get more insight from the purpose driving the business or insight than ‘trends’...if the narrative for the investment is the trend, the space, the concepts versus the tactile reality of purpose, I have zero interest.”- Peter Fenton (Twitter, Yelp, Elastic)
“I don’t have a profound sense of what technologies are happening...everyone says the same things. Sequoia’s job is to follow the declining cost of computation...all these big ‘trends’ will happen but who knows on what time scale?”- Mike Moritz (Google, Yahoo, Stripe, Instacart)
“Our primary shared value is radical open-mindedness; we constantly question popular narratives in search of hidden truths. We believe this is especially useful in venture investing, where capital tends to be dramatically over-allocated to startups that align with the strongest market narratives.” - Geoff Lewis & Eric Stromberg (Lyft, Wish, Lambda School)
Despite these cautionary words, one of the first things you will be asked in a venture interview is what sectors and trends you believe are going to be big in the future.
What’s going on here?
A few things:
From the outside looking in, the job of the venture capitalist is to predict the future and then make investment decisions based on that view.
Venture has such a long feedback cycle that investing in hot sectors/trends creates a more immediate signal about the possible success of investments
Thesis-driven investing gives a degree of confidence that the investor knows what he/she is doing, both to LPs (the investors in the fund) and founders. Specialization also may help close certain deals.
Predicting the Future
Benchmark is probably the firm who most radically opposes predicting the future. Fenton talks about how he came to Benchmark from Accel with the understanding of needing to have a “prepared mind” for segments or categories. A fellow Benchmark partner told him to “throw that crystal ball out, you can’t predict anything. What you can do is recognize when lightning strikes.”
This has led to the famous Benchmark axiom of “Our job is not to see the future, but see the present very clearly.” What this practically means is understanding the technological preconditions that enable a business to be possible but letting the entrepreneur tell you what the business is. To nail Uber, it was critical to understand mobile phone ubiquity and the incredible improvement in GPS technology. It was not necessary to be looking for investments in the “gig economy” or even in “disrupting taxis.” In fact, no one knew what the gig economy was before Uber. The best startups don’t fit into convenient buckets, rather they create entirely new and enormous markets.
If you define your thesis around hot sectors, you could also miss a Google. Google entered search extremely late after some IPOs and a dominant player in Yahoo. Search appeared to have been won. To quote Fenton again, “When you have the greatest certainty about the future, you make the biggest blunders...and don’t see the subtleties of a great entrepreneur who has a point-of-view and meaningfully differentiated experience.”
Mike Moritz puts it a different way: the investing business in technology covers such a wide range of things you can’t possibly know about everything. What you need to be able to do is start knowing nothing, quickly gather facts, and then make a well-grounded decision afterward.
Generational companies will not fit in a VC’s pre-conceived notion of a “request for startup” to share on a podcast. The next $50b company won’t look like Uber or Facebook or likely even be in a sector that everyone agrees is the “one” to invest in.
In poker, there’s near-instantaneous feedback on your decision. This can be a bit misleading as one often makes the right decision with poor results. However, through thousands of hands, one can arrive at an understanding of which decisions are generally correct and which are not. This tight feedback loop is one of the primary reasons online players improve(d) so much quicker than their live peers. It’s not perfect but the process for improving decisions is clear.
In venture, things are a lot more hazy. IPOs may take place eight or nine years after writing a seed check. In the meantime, you’ve deployed millions of dollars more in investment decisions, collected beaucoup management fees, and probably raised one or two more funds. You may not even remember why exactly you invested in that particular startup. With such a long feedback loop, how can you possibly know the signature of a good decision? More importantly, are you really making a decade’s worth of decisions without any feedback on your thought process from when you started?
Well, not really. Startups go through funding cycles and these intermittent markers are signals of health. One seed investor I spoke to told me that the way he improved his decision-making process was by seeing how quickly his deals were raising their next round. If it’s been two years and none of your seed investments have raised a Series A, you might be doing something wrong.
My intuition is that one of the best things about investing in a hot sector or trend is the faster feedback loop. First, you win a hot deal beating out other venture firms that were vying for the startup. That feels like a good decision. Moreover, this compounds with quicker future fundraising. As Lewis and Stromberg point out in their original Narrative Violations letter, “capital tends to be dramatically over-allocated to startups that align with the strongest market narratives.”
Early investors in the e-scooter business got fast and significant markups on their portfolio. Same with those investing in the daily deals business after the early success of Groupon. Yet eventually these hot sectors turned out to be nothing more than mirages and when the tide went out, we saw which investors were swimming naked to paraphrase Warren Buffett.
Investing in the trend du jour creates the mirage of good decision-making. It’s very likely your startup will initially grow very fast and possibly raise its next round or two at soaring valuations. But things can evaporate just as quickly as they rise. Just look at WeWork. Marking up the portfolio may look awesome to LPs and buzzy at cocktail parties, but until capital is distributed, it’s all paper gains.
Of the three reasons for investing in specific sectors or trends, I believe this is the strongest reason.
For LPs, allocating capital to a fund without a thesis or track record seems borderline insane. It’s all well and good for Tier 1 firms like Benchmark and Sequoia to pontificate about investing only in the best entrepreneurs, but a new VC fund with no brand name trying to raise $100m for their new seed fund better have a thesis for what they’re investing in and why they have a differentiated competitive advantage.
Investors can also specialize deeply in a particular industry and become the go-to for founders in the space. What crypto founder would not start with Paradigm? Where I believe this becomes riskier is when venture investors believe they can see the future and have specific requests for startups.
Venture investors are on their side of the table for a reason. Their job is to be stage hands or ‘consiglieres’ to extraordinary founders who have a unique insight they want to manifest into the world. Venture investors who think they can think of startups or request certain ideas run the massive risk of favoring ideas that sound good in theory, but are failures in practice.
Founders bring the insight, not VCs.
“When an entrepreneur pitches and tells a story that provides an insight that makes you think about the world differently, that’s when I get really, really excited...And that’s why we don’t tend to be particularly thesis-driven.” - Eric Vishria (Amplitude, Benchling, Confluent)
As someone new to venture capital, my first instinct was to start predicting the future. I wanted to have deep opinions on fintech, edtech, healthcare, and all the industries in between.
However, after studying some of the greats that have invested in some of the best startups ever, my new view is that my primary focus must be on finding and investing in extraordinary founders while having a prepared mind around today’s technological and societal preconditions.
Two of the most interesting startups I’ve seen recently are Stedi and Bottomless. At Stedi, Zack Kanter is building a modern trading network by standardizing and automating the antiquated infrastructure for commercial transactions that currently often requires point-to-point implementations. Through this simplification, Stedi could eventually sit in the middle of a massive B2B transaction market (trillions of dollars). Michael Mayer is the CEO of Bottomless, a smart coffee subscription. I’m a customer of Bottomless and it’s magical when a fresh bag from some of the best roasters in the country shows up at my door just as I’m running out. There’s a whole host of possibilities beyond coffee that are bubbling just beneath the surface, but Michael is following the Amazon example of dominating in one category first before expansion.
As you can see, neither of these companies fit into today’s buzzword categories. However, I find them compelling because of the quality of the founders, the potential size of the market they’re attacking, and a clear story for why today is the right time for their companies. In the future, I hope to continue to overindex on these aspects while staying away from the mimetic lure of the hot sectors at the top of VC Twitter.
Would love feedback and thoughts on this article! As I mentioned before, this newsletter is a way to open-source my thinking as I start from the ground up in my understanding of venture capital. I’m always looking for ways to improve my thinking and decision-making.
Nutrition Tidbit of the Week
Matiz sardines are by far the best sardines I’ve ever had. Super meaty and not overly fishy, I eat at least one can a week to help boost my Omega-3 and DHA/EPA intake.
Book or Podcast of the Week
Kochland is a fascinating look inside Koch Industries. It takes a fair look inside the company’s controversial past while still painting an intimate portrait of Charles Koch’s market-based management philosophy and powerful business mind. Whether you’re a dyed-in-the-wool anarcho-capitalist or a fervent environmentalist who thinks the Koch brothers are the devil incarnate, the book is a must-read.
A major problem with this Founder-Investor model, is that investors are inherent diversifiers, whilst founders are inherently putting maximum risk on themselves. Conventionalism or Secondary Investor v Barbell Strategy and Primary Stakeholder. Blackjack with Card Counting (quant) vs Pro Poker and Independent Games (quality). https://twitter.com/vgr/status/1277262959828283392
Ideas to consider would be to pair Lindy Effect against Black Swan Events, or witnessing how fast things and antiquated things end differently, and how others take their place. Practically everyone from Samo Burja to Ray Dalio is trying to bet on who will win, whilst those like Peter Turchin and Rensselaer Polytechnic is taking averages and thinking about when things will change.