As I have continued to get older, and watched my age cohort becoming more successful, I occasionally encounter people who have made a lot of money in an unrelated field, and now want to become an investor. Naturally they ask me for my advice on investing like a venture capitalist. (A prominent subset of these people are interested in “impact investing”, eg not doing it for the financial return but to help others or some other goal – I’ll touch on this aspect as well towards the end.)
Similar to my advice on trying to get a job as a VC, my answer is: don’t. But if you have to, it turns out there are actually some pretty good heuristics you can use. Let’s dive in.
This is a longer one, so here’s a brief tl;dr:
- Don’t invest in startups!
- Invest in top-tier VCs if you can
- Invest in new/small VCs with extremely narrow, deep expertise in a niche area
- As an investor in VC funds, try to invest alongside them in later-stage deals
- If you are investing directly, do not lead the round, do not offer term sheets! Let other VCs do that part
- You can hire outside experts for technical diligence, but this alone cannot rule in investments
- The single most important attribute of a startup CEO is whether they can SELL, and you can tell!
- A distant second is singleminded focus, avoid any startup where the leadership is hedging or easily deterred
- Impact investing doesn’t change any of the above, you cannot lower your standards for investments
Before starting, I have to tell you that VC investments are overrated. Returns are dominated by just a few big hits, and those big hits are concentrated into a handful of the top VC firms. If you are strictly seeking a financial return, you should go into other types of private equity, or just standard public equities. It’s fun and exciting to be part of the startup/VC ecosystem, but it will most likely end up as a waste of time and money. If you still insist on going down this road, then read on…
As you can guess from the above paragraph, the best way to invest in VC is not to do VC yourself, but to get into one of the top funds mentioned above. Generally this is pretty difficult to do, as the top funds are usually constrained by how many good opportunities they have, and thus the amount of capital they can deploy without sacrificing returns. This means top VCs are always oversubscribed on new funds, and they usually prioritize long-standing relationships over newcomers, so your odds of getting into a top fund even if you’re wealthy is not good. If you are exceptionally wealthy and stable and they expect support for many years, and even moreso if you’re wealthy because of a hot new area the VC would like to understand and network into, then you have a decent chance at being let into a new fund from a successful investor. Usually the top partners will at least take a meeting, and it’s good to get them in your Rolodex.
Is it worth investing in new/small funds? On average, absolutely not. What exceptions might there be to this? The top one in my mind is investing in a new fund that’s highly focused on a new/niche field, and the founding partners are exceptionally networked/talented/successful in this new/niche field. This could allow you to produce returns in unexpected places. What’s also nice about new funds is that they tend to be raising modest amounts, like $100m or less total size, and that’s an awkward size where the largest allocators like pension funds couldn’t write small enough checks to meaningfully invest, but that’s more than a handful of millionaires could fill themselves. In this case, mid-sized family offices have a chance to get in early, if you’re willing to take a major gamble on this new talent.
But no, you tell me, you don’t want to invest in VC funds, you want to invest in startups directly! Okay, I’ll give you the best advice I can, but don’t say I didn’t warn you!
I’ll punt on the direct question one final time and give my first tip: invest in VC funds to get access to good startup deal flow. In the smallest, earliest stages, VCs can easily fund an entire company themselves, so early rounds they tend to have a small, tight syndicate, and it’s unlikely you can pursue this strategy. However, as you leave the seed and Series A rounds and start getting towards growth rounds ahead of an expected IPO, suddenly the check sizes get a lot bigger. Whole classes of investors (usually called crossover investors, as they also hold public equities) jump into private companies at this stage, but if you have good VC relationships and lots of money there’s an especially good chance you can participate at this stage as well. VCs sometimes set up sidecars, where you can put in funds to specifically invest alongside them, rather than through the VC fund itself. Other times you can just directly invest, and they’ll hold open room in the round for you. Of course investments can go south at any point in the process, but generally, growth rounds are only being raised if the company is already on a clearly good trajectory. The biggest risk is often that a falling public market means the IPO window is closing and the company might need lots of private rounds in intervening years before they get another shot at going public.
But suppose you weren’t able to get in on a top VC fund and get access to invest alongside them. There’s one final trick up your sleeve to rely on VC funds as a direct investor: don’t lead rounds! No matter how tempting it is, no matter how good the company seems, just refuse to lead! Founders/CEOs absolutely hate this one weird trick, because of course everyone wants to punt on the decision making, but that’s okay in your case. It’s not your job to make their life easier, it’s your job to a get a return (ideally a good return, but any return at all means you live to fight another day instead of going to 0). You can even put further caveats: you’re in for X% of the round, conditional on them getting a great investor to lead the round, not just any old random term sheet from someone not listening to my advice. Generally, if you’re investing alongside a brand name investor, that brand name investor has pretty good reason to think the company is good, and you’re free riding on their diligence process. The fact they are investing at all is a strong signal.
Now my advice goes into the untamed wilderness, and you’re likely to get eaten alive, but yet you persist against my better advice! I understand – maybe you’re not the high net worth, maybe you’ve been tasked by the HNW to find investments for them, and they won’t take no for an answer. It happens.
Since you’re coming into the field as a non-expert, you can’t meaningfully do due diligence on the technical aspects yourself, and I don’t recommend that you try. Lots of firms will hire outside experts with the relevant knowledge to evaluate a proposal on its technical merits. It’s fine to hire these people if you want, though it is a mixed bag as well. If they give you a thumbs up on the technical side, that does NOT make it a good investment, it just doesn’t rule it out. And frankly, if they come back saying something is crackpot/doesn’t make sense, they’re probably right, but also they might just have their own biases from their experience in the field, and startups are necessarily disruptive. At the very least it will provide you some follow up questions to ask, and you can decide whether you like the type of answers you get back. On some level, if you’re playing this game, you’re really weighing whether you like the epistemics of the expert or the epistemics of the C-suite more, or other intangible factors.
But as a fellow human, there is one thing you’re probably qualified to assess, and that’s whether the team is charismatic. There’s that old saying in VC, that we invest in people, not in companies/ideas – and it turns out that’s really smart! Unless a VC is extremely focused on a very narrow field, they are necessarily a type of generalist. It’s rare to know a field as well as the people you’re investing in, so there will always be asymmetry on technical knowledge. But ultimately the success or failure of a startup is measured by one thing: did it get to a successful exit. What’s the most important single skill for getting a successful exit? The ability to SELL. The CEO is in the business of selling, almost exclusively. At the founding and earliest days they’re trying to sell the vision to potential cofounders and new hires. If they’re B2C or B2B they’re selling a product, and that’s reflected in growing recurring revenue. If they’re a biotech, they’re selling Big Pharma on an acquisition or a co-development deal with big upfront and milestones. Literally every single startup is selling their investors on investing more money into a company. If a startup cannot raise money, they die. So the single most important thing before an exit is fundraising. And the question of whether they can SELL is first and foremost results to date, and the second is how compelled you are by their pitch. How compelled you personally feel is highly correlated with how compelled everyone else in the process feels. If you feel like they pitched you well, others will too, and they’re far more likely to succeed than if you leave the meeting with any doubts in your mind.
(You can evaluate other intangible factors, but probably the only other one that’s predictive is their tenacity and single-mindedness in pursuing the startup. If they’re hedging in any way, like selling some of their own stock in the company, it’s a red flag.)
Of course the obvious concern here is that if you’re evaluating solely on charisma, you’re vulnerable to fraudsters. That’s absolutely the failure mode of this strategy, and we see it happen all the time. There is no perfect strategy with no tradeoffs. I told you not to directly invest multiple times, but you insisted, and this is your best shot at getting it right! In the most cynical version of this strategy, even if the company is completely fraudulent… if the fraudster is good enough at sales they might get to an exit anyway. Or in the less cynical version, the product doesn’t work but no one fully understands that (like a drug that looks good in preclinical but has a bad Phase 1), and the founder is able to salvage a decent to very good exit on sheer persuasion, saving your capital from annihilation. Or the least cynical version: the company is great, product is great, it’s destined for glory and success… but the CEO still has to negotiate their purchase price when selling the company! The difference in multiple between a charismatic and a bumbling CEO is enormous, and to succeed in this game you need everything pulling for you.
Your final objection could then be, this is all well and good, but I’m not in it for the money, I’m in it to help save the world. Great, I’m all for that! But I think this changes the situation less than you might initially think.
Deciding to fund a non-profit is a totally different decision, and one I know some but not a lot about, and you then have to develop non-market mechanisms for success/failure signals and whether to give them future donations. Markets are actually pretty good (not perfect) at figuring out what’s valuable, so you should always be careful when going down the non-profit road.
But this is a conversation about investments, not donations. Whatever this project is doing, they decided to make it a for-profit, not a non-profit, and so you have to evaluate it as a for-profit business. If they’re providing a valuable good or service, there are people who will pay for it, and if not, then it’s not as valuable as you think – or they never should have been for-profit to start, and they made a huge mistake, which means you should question their judgment. (Side note: B-corporations are for-profit entities, with very little in the way of legal requirements making them act like non-profits. You should always treat a B-corp as marketing, maybe very good marketing which is itself a good signal, but it should never change your approach to evaluating them as a for-profit!) And what is the most important skill in a for-profit venture? That’s right, the ability to SELL. It’s exactly the same analysis as above! If your “impact” investment is going to succeed as a for-profit, it has to actually stand on its own two legs as a profitable enterprise, and NOT rely on the goodwill of uncritical impact investors.
I am trying to hammer this home, because I think the natural path impact investors go down is that they 1) focus more on product and less on sales, 2) invest money at unreasonable valuations given real world traction, 3) tend to re-invest in failing ventures, 4) often become the only source of new funds, and ultimately 5) lose lots of money. Finance is an infinite game: the most important thing is to play to keep playing. As soon as you go to 0, you’re out of the game forever (at least until and unless you make a second fortune, which is extremely difficult but not impossible). Impact investors who do not focus on making profits from their investments will become a smaller and smaller factor in the market. If you want your companies to have impact, they have to be successful companies, not a list of excuses for underperformance. A failing impact investment has no impact. So take this seriously, treat it like an investment, and don’t give them a special pass because they fit some criteria you like or they spin a good story aimed at your mission.
Hopefully this helped either dissuade you from private investments, or if not, helped you make some better decisions – mostly by avoiding the bad companies, even more than picking the good ones. I wish you the best of luck on your investment journey!
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