Thursday, April 4, 2013

The Signal and the Noise (Angel Investing 6)

[Note: Post Number 5, on modelling your portfolio, was supposed to be next. Then I asked my friend Chris Wiggins a naive question about power law distributions. In return he sent me this paper. And this software. And this syllabus. And this paper. And this video. And also this talk he gave, which was above my pay-grade. And then I read the papers and watched the video and I was enlightened. And then I ran the software and it told me that the returns in the AIPP data were not power law distributed, that it was far more likely they were log-normal distributed. And I knew there would be a whole 'nother set of papers and videos and online coursework. And so I threw up my hands and wrote this post instead. I'll get back to the other one when my brain recovers.]

A long-time VC at a top tier firm said to me the other day: "we used to talk about proprietary deal flow, but that doesn't exist anymore. Good ideas can get in front of anyone and good founders make sure they do." Mahendra Ramsinghani* makes the same point yesterday on PEHub. It's true.

There was a time, say three years ago, when you could see great deals that no one else saw. That time is gone. Great deals are seen by plenty of people. Anyone can easily invest alongside me, or David Lee of SV Angel, or Founder's Fund, or almost any other great investor.

But this does not mean that you will automatically see great deals. Deals don't just suddenly start landing on your desk the day you decide to start investing. You need to make yourself known, then you need to make yourself wanted, then you need to make yourself needed. That takes some work.

And then, as soon as you start generating signal, you have to deal with the noise.

As an investor you will see a lot of potential investments for each one you make. Venture capitalists say they see 100 plans for every company they fund. There are a few reasons for this:
  • Most businesses should be friends-and-family funded, or bootstrapped**, not venture funded;
  • Most startups that should be funded should not be funded by you; you should invest in what you know: the people, the market, the types of activities the firm will need to excel at to thrive;
  • You may see several companies solving the same problem at the same time, but you probably don't want to have too much bet on a single problem;
  • Related, you will need to say no to good companies because they are too similar to companies you've already invested in;
  • You won't know which are the best new companies unless you are seeing a lot of them***, you won't know where the market is pricing companies if you aren't talking to a bunch of them, you won't know what problems companies in that industry are facing, you won't know which other investors are actively in the market, etc. 
You want to see many of the deals you end up not investing in. Venture investors traffic in information. Good venture investors are great information processors. Looking at companies is the best source of information out there. But a lot of deal flow is unavoidably noise to you, not signal. Although I would be interested to know more about the wave of online consumer subscription retail startups, for instance, they are too tangential to my main investment theses for me to spend the time meeting with them all. I need to just say no and move on.

Once you open the door to any and all deals, you're drinking from a firehose. You can't look at everything. You need a mechanism to filter for the deals that fit your criteria, and you need to do it in a time-effective way. That may be the harder part of deal flow: not quantity, and not quality exactly, but finding the needle in the haystack.

Ramsinghani correctly chides the VCs he's invested in to no longer consider proprietary deal flow a competitive advantage. But I don't think it means what he thinks it means. VC investing has become democratized. But the result is not that everyone now has the same advantages, it means that everyone now has the same problems. Established VCs have processes to separate the signal from the noise. You need them too.

Next: Generating deal flow

Previous posts in this series
  1. Intro: Why I'm Not an Angel
  2. How to spend your time: The Work-Work Balance 
  3. Positioning: How to be Different When What you Sell is a Commodity
  4. Portfolio Construction: Transcending Hobbyism 
    1. Data sidebar: AIPP data summary
    2. Data sidebar: AIPP exit data 
  5. Portfolio Modelling: TBA
* Who, btw, wrote the book on venture capital as a profession: The Business of Venture Capital
** For many reasons--the return needed to compensate for the risk around a raw startup, the need to get to a cash exit (not just a sustainable business), the principal-agent risk, etc.--most startups should be self-funded or backed by friends and family or supported by the founders starting the company on the side. The National Venture Capital Association says that in 2011, only 973 startups received their initial venture capital funding. CB Insights has said closer to 2000. In comparison, the Bureau of Labor Statistics says that in March 2011, there were 536,445 establishments less than a year old. These numbers are not apples-to-apples, but the point is that far fewer than 1% of new businesses take venture money.
*** Saying this may rub some entrepreneurs the wrong way, they don't want their time wasted responding to fishing expeditions. I agree. Do not waste entrepreneurs' time. Be honest. As soon as I decide I'm not investing, I tell the entrepreneur. If that's before the pitch I also often tell them that I would be happy to sit down and hear their pitch anyway. Many times they take me up on it. In return, I try to be helpful: constructively critiquing their plan, offering to make intros to portfolio companies or other potential partners, etc. My existing portfolio companies always come first, but in almost all cases in the startup world, the competition is not other startups, but established companies. I like helping startups, and if I can help without disadvantaging the companies I've already made a commitment to, I will.


Carrie Mantha said...

Thanks for these thoughtful posts, Jerry. They coincide with some of the best thinking (IMO) in the public markets as well (your discussion of intentional risk and unintentional risk captures a lot of what is missed by even guys who try to run beta neutral portfolios).

Most interesting to me is this conflict between an angel's need to see a high rate of deals and a disruptive startup's likelihood of seeming 'crazy' on first glance/quick triage. Does that mean that generalist investors are inherently flawed because they can't quickly grasp the nuances that differentiate a startup? And does it become dangerous at some point to not follow the changes in tangential/potentially related fields?

Jerry Neumann said...


Wow, ok, that's a deep question.

I think, in fact, that it's the specialists that are least likely to acknowledge the possibility of a disruptive idea's potential. Most specialists invest in a disruptive thesis, the companies being disruptive by virtue of being part of that thesis. Companies that challenge that thesis are thus outside of it.

I do think it's dangerous not to keep abreast of adjacent fields. Most venture investors I know obsessively track pretty much evry deal in their sector (consumer internet, enterprise software, etc.)