Expert Advisor to the European Commission
This is not written from years of experience. It is a collection of notes from discussions and thoughts over the past months and part of my effort to make sense of the topic. I would like to thank @justvideesha, @drosskamp, @simonschmincke and @benediktherles for the discussions, and especially @alexruppervc for their feedback.
This article specifically looks at early stage investing. As you go later stage in venture investing and towards the realms of private equity and public equity investing, historical data grows in importance as the basis for analysis. The number of late stage private equity or public equity investors writing about their investment thesis rises — see for example the classic “Intelligent Investor” by Ben Graham.
There is some confusion as to what a “thesis-driven approach” even describes in venture investing. While Wikipedia helps us in defining the term as “a concept or idea that can be falsified by various (scientific) methods“, the application of this process may take two forms in venture. The produced position paper about a sector or deal will also shape the terms the investor is ready to propose or accept in deal negotiations later on.
Thesis-driven Definition of Investment Focus
“Thesis driven investing involves drawing a picture of where your particular area of focus is going”, says Fred Wilson of Union Square Ventures. As David Rosskamp puts it: “Deductive thesis investing starts with a vision of the future. The investor will formulate a narrative of a target industry’s development and map out the individual elements that will be needed to spur that narrative.”
The process normally starts with intense learning about the sector, from own experience, industry experts, science, and potentially drawing parallels from similar fields. This method can then be applied to different “dimensions” of a thesis.
The outcome of theses can look like this:
An alternative approach I have seen in other funds is what I would call “competence-based” investing. Implicitly, most investors do this: There is only a limited number of markets or business models any given VC understands based on own experience. Investments are made either in the combination of promising markets vs. known business models (Point Nine Capital) or known market vs. promising business models (Berliner Volksbank Ventures). Some investors add a third dimension around “value-add”: They only invest in companies where they know they can either be a customer (Santander InnoVentures), help with public relations or marketing (DvH, Project A) or can support operationally with experienced investors from their investment team (SpeedInvest). This has a lot to do with the branding of venture capital firms (see Florian Heinemann’s / Joel Kaczmarek’s Podcast for an exercise of the German VC landscape) and is sometimes used as an argument in competitive deals.
Thesis-driven Company Analysis
A lot of former strategy consultants and equity analysts are joining the ranks of private equity and venture capital every year, bringing with them a strictly regimented methodology of hypothesis-led analysis. While researching a business, initial theses about the market, team, KPIs and/or business model will be rejected or validated — informed by the data produced from fundamental analysis or supplied by the venture to the investor.
We use this approach ourselves as it not only helps structure the analysis but also tracks the train of thoughts and uncovers biases in the initial deal assessment.
Voices from the Industry
While I am still structuring my thoughts, other venture investors have spoken or written about the process of building an investment thesis.
Scott Belsky of Benchmark: Scott is summarizing his method as “invest your energy and money in the overlap of what excites you (the opportunity), and who you respect (the team).”
Brian Laung Aoaeh of KEC Ventures: Bryan describes the process of investment analysis in the early stage ventures as a debate between art and science.
Taylor Davidson, formerly of kbs+ Ventures: Taylor “traditionally thinks about startup and investment opportunities through broad frames, sectors and trends.” He then goes on defining his thesis in eleven statements and provides reasoning for every statement.
Union Square Ventures in 2012: USV defines their thesis as “a macro level view about the world — the Internet world — that we then (attempt) to structure investment activities around.”
Thinking Around The Next Corner — A Reality Check
Diversification and conflicts of interest: Venture returns follow a power law, the chances are slim that one bet on a thesis will result in a home run. The venture industry has not shown to be very good at picking winners. In order to diversify risk, this would mean building a balanced portfolio of companies based on a thesis. (It is kind of funny and speaks volumes about the intricacies of venture investing when you need to use the terms “power law” and “balanced portfolio” in one paragraph.)
Investing multiple times in companies that fulfill all the checkmarks of a more specific/narrow investment thesis will create a conflict of interest for the investor: If portfolio companies consider expanding into adjacent offerings, they may start competing with other portfolio companies. How can we address this problem?
The reality of investing shows: Very few companies in any given market niche are both great businesses (team, traction, product, market) as well as a great investments (pricing, cap table, deal structure). It takes intensive networking and deep research to identify the investment opportunities we are looking for at Redstone.
I will start publishing our thesis on some of the (sub-)sectors where are looking at over the next couple of months. Looking forward to the debate!
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