by Noah Jessop
As an entrepreneur, I pitched and got the chance to work with a number of great firms. But when I came to the venture side, there was a whole new element I’d never really considered before, quietly shaping the entire ecosystem: an investor’s deal flow.
Now, as I talk to other investors, the concerns around deal flow was pretty straightforward:
How do I get more good deal flow? More is better. Where can I cultivate to get future good deal flow?
And that’s generally where the conversation stops.
There’s a term for the constantly changing source of new customers in operating companies: media mix.
As an operator, how can I expect to run my business the same when the leads or potential new customers are coming from different sources? We expect additional competition on an important keyword to change an operating company’s ROI. But when applied to venture capital, the media mix question quickly gets lost. Unlike an operating company, who must convince each and every customer to pay their price, in some percentage of instances, investors actually control the conversion event. (i.e. if they offer money on good terms, it will be accepted.)
So looking at conversion rate hardly scratches the surface. What follows are the questions that are still unanswered for me.
To start to consider this question, I’ve found it easier to use Charlie Munger’s mental model of inversion:
What would you do to have an edge as a new fund?
I’ll argue it’s simple (and not entirely intuitive): look more closely at the investments you can access.
Sometimes new startups complete their financing very quickly — either with firms they’ve known for a long time or by running a tight, competitive process. But more often than not, they meet a few reputable folks via their angels and advisors, maybe even before they’ve started to really tell their story the best they can. (Or maybe even before they’ve decided to raise.)
These earliest pitches — where it’s not clear whether the company is raising — often get missed by firms with a lot of high-quality deal flow. I’ve written at length before about how rounds need to get packaged to move swiftly. No matter how high quality the team, how good the market, these early pitches can just get lost in the noise. Not necessarily better investments — but teams that already have a term sheet, have unlocked a major traction milestone, or simply are just a few years further along as a business.
Most rounds take a number of weeks or months awhile to coalesce — as teams hit new milestones and get better at telling their story:
Time on X-axis, Traction & Quality of team’s pitch on Y-axis
In any given deal, when do new firms have an edge? Before it’s clearly a winning company (at least at this stage) to other potential investors.
How do they capitalize on this edge? New fund managers, their industry specialties and existing relationships aside, simply have more time to develop conviction for a deal. They have fewer new meetings to take and less of a track record that will allow them to win deals that they come into late.
So when they see a business that they understand (or they meet founders they particularly like), they have more time to de-risk the parts of the story that aren’t yet entirely clear. Put another way: some of the overlooked outliers will turn into incredible investments. But more deal flow lets investors put these opportunities in the “too hard” pile and focus their time on other safer bets.
Only seeing deals when it’s too late isn’t helpful for most investors. But consider a common case for the best firms:
Deals often end up moving too slow and then too fast. It’s hard for a VC to start looking at a deal when things it’s already moving very quickly. It’s often very difficult for a new investor considering leading a round, no matter how much they like the business and founders, to do the requisite work to reach conviction for an investment in this compressed timeline.
For founders to consider a new suitor late in the process, when there is still uncertainty about whether they are willing and able to invest, that firm must be in such high regard to slow the founders from accepting an existing “bird-in-hand” term sheet.
Most VCs say that they want to meet companies early and get to establish a few data points along the company’s progression. This progression is helpful only if the company doesn’t accelerate beyond the stage of checks that given firm is able to write.
Few will say it, but sometimes, it’s just less work to meet a company when it about to start a proper fundraising process — moving fast enough to know the deal will happen, but slow enough to get to do the diligence that firm wants to do. A lack of diligence or a relationship will be soon be justified to a partnership by saying, “it became a very competitive process and we wanted to win this opportunity.”
As a founder, I always called the coalescing of a round “creating a discrete moment of FOMO” — my advice now would be to indicate when things are starting to move early…but only when there’s good certainty of the deal progressing.
Venture capital is a business of exceptions and outliers. More often than not, it may take a few years before we have any understanding of which investments actually stand to be “good” — and even then, actual investment success in any given company can’t be counted on until meaningful liquidity is realized.
So we look for shortcuts. We look for proxies that we — as investors — are doing well. That we are seeing the companies that will matter in 5–10 years.
Unfortunately, the ‘hot’ deal is a readily available, and overused, shortcut. Competition at the fundraising stage is a cheap proxy for eventual success. Often, when everyone wants to do a deal, it might be because it’s consensus sounds right but isn’t.
Worse, investors early in the cycle of building their portfolios may be led astray from the eventual returns by chasing hot deals. The short-term incentives these VCs face make it important to do something hot and consensus, with the hope that it will have appreciated by the time they need to raise more capital for their next fund.
Similar challenges exist at older, more established (and possibly more political) firms — sometimes “hot” deals are easier to get through the partnership. Winning a deal from other suitors may be justification enough to invest.
This whole process creates a Keynesian beauty contest of startups — investors speculating which companies will look most appealing to future investor’s belief of what other investors after them may like. (In the original, Keynes proposed a contest where the “correct” answer was to guess which faces the rest of the crowd might vote most popular.)
This exercise, by definition, is something else in disguise: reversion to the mean.
Hardly helpful for investors seeking outlier performance on the logarithmic-style outcome result field of venture-style exceptions. One method to break this model is simple: investors might pay the very highest prices for the deals that likely are truly outliers AND already widely discovered.
Ironically, investors spend a lot of time thinking about a prospective investment will acquire new customers and grow — looking at how the company’s user acquisition costs and channels will change as the business scales.
But as we mentioned earlier, an investor’s own “media mix” is changing — and they control the conversion event, so hard to track really what’s happening.
Add this to VC’s slow feedback cycle: investors really don’t know the outcomes of their previous deals. Going forward, structurally they can only invest in deals that are part of their deal flow.
All of which is to say: an investor’s strategy is tightly coupled (and easily changed) by the deals that they see.
Getting lots of referral deal flow takes up time — and can fill all the time and space for potential opportunities. For example, how many high-deal-flow venture firms chose to invest in the Ethereum ICO? (Which today, presuming you didn’t sell at all along the way, would be an 1,800X return.) Good deal flow may be helpful, but it may look “startup-y” (or now “crypto-y”) and nothing like how tomorrow’s outliers will start.
In addition to having less time to evaluate new opportunities and greenfield areas, more deal flow has a hidden side: investors will progressively see more companies at the later stage of traction for their stage. Why? In choosing which companies to spend time with, commercial traction is an easy (and relevant) shortcut. Why look at the business doing $50K monthly revenue when you can look at one at the same financing stage doing $200K?
One might argue that firms raising progressively larger funds and moving later stages isn’t just about collecting more fees — it’s just about capitalizing on the deal flow that they have naturally built over time.
I witness many investors seeking to invest in “high quality” lead sources. While certainly there’s positive signal from where founders previously worked, or who previously invested, it’s helpful but not sufficient. Else, top investors could simply back every Google and Facebook alum and make it so.
If investors establish all the “good” lead sources and see many of the people coming out of the top few companies — how can they think they will have differentiated flow? We established above, seeing things the very earliest, in most cases, isn’t necessarily an advantage for winning that deal.
The “great” source of the next outlier deal is truly unknowable by definition.
The best an investor can strive for is to build their reputation (and stand for something) and travel far and wide…
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