VC Fundamentals Part 2: Investment Decisions

Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Ben: Welcome limited partners to our second VC Fundamentals miniseries episode. As you will recall, the first one was on Sourcing. This one is on investment decisions, specifically initial investment decisions. Then we'll go in the future through company building, portfolio management, fundraising, and firm management. 

We've also retconned a few other episodes into our VC Fundamental series. Our interviews on consumer investing in enterprise investing with Sarah Tavel and Chetan Puttagunta from Benchmark. We found a nice old groove here.

David: We might have a few other old episodes we could retcon in here. 

Ben: Yeah, particularly the diligence one is probably reasonable.

David: That will come up on this episode for sure. This episode is not necessarily about the craft of investing and investment decision making. We talk about that obviously a lot on the main show and elsewhere on the LP show.

Ben: Like what should you invest in, when, and why? 

David: Today is about the how. What we don't talk about as much (I don't think) is the mechanics of how all this stuff happens behind the scenes. And actually, despite all the VC content out there in the blogosphere—is that even a word anymore? 

Ben: I think people say VC Twitter now.

David: VC Twitter, right. I think this is pretty hard to find information. How do decisions mechanically actually get made at VC firms, initial investment decisions, and what are all the dynamics behind them? So that is our goal today.

Ben: If you're deciding like hey, is this episode for me? Our goal in doing this is I guess severalfold, but I'll give two sides. One is if you want to become a VC, it's great to become versed in this stuff, so you have the language to use as you think about potentially breaking into the industry, starting your own firm, or anything like that.

But probably more relevant for more listeners and the net higher societal good is really just about understanding how the person's thought process and world works. If you're a founder of a company or if you are engaging with a venture capitalist on anything to understand basically what's their job. That's really the through-line of all these VC fundamentals episodes.

David: I said it before, I'll say it again. Know yourself, know your enemy, know your situation, Sun Tzu—wise man

Ben:  I was trying to avoid using the word enemy, but you said it.

David: Let's start. In the last episode we talked about sourcing. Sourcing is all about you're a VC, newly minted or otherwise, and you're top of the funnel. You can only invest in your universe. The only things you can invest in are companies you see. Today, what happens after you find something? You see something, you decide this is interesting. What happens after that? 

The real answer is a whole lot of random stuff that very much depends on the process, very much depends on the firm or the investor. We're going to talk about all of it today. The first piece is diligence. We did a whole episode on diligence, but this is more like you hear VCs refer to this as digging in, “I'm digging in on this company. I'm doing work.”

Ben: They immediately start googling all the words that you used. 

David: That is probably the first step. It's either they are googling themselves or an older senior VC. They’re probably assigning an associate to google you, google your competitors, google the market, google your customer, and all sorts of things. 

What you’re really trying to understand first is just the nature of the market. Who are the customers and the users? How big is the market? Who are the competitors out there? Who are the substitutes? 

We just did our LP book club with Hamilton Helmer and he talked about—I don't think this was in the book 7 Powers—the three S's. This is the significance of the S’s. Why is what this company is doing significant and how significant?

Ben: What we're Hamilton's two other S’s?

David: They were superior—that's the benefit, the significance is how meaningful this is, how big it is, and then sustainability—that's the barrier to power.

Ben: And the significance in this aspect, this is where they're deciding is this something that is going to generate venture returns at all before I even get into the business model? Is there going to be a billion-dollar company that solves this need for someone?

David: Yeah, whether that's this particular company or something else. That's the what here. But here's what's really interesting—and all of this we're going to try and talk about different stages of investing like early stage, seed stage versus growth stage, and later—especially at the early stage, for this is going to be a theme everywhere.

This seems pretty straightforward. You're doing some Google searches. You're talking to people in the space. You're getting smart. It seems pretty straightforward, but it's really easy to get this wrong and look really stupid later, and how and why is that? 

It's because what matters, especially at the early stage when you're making investments, is not the market size and dynamics today. What matters are the market size and dynamics tomorrow, and this is where really a lot of the art comes in and people talk about timing in terms of investing. 

It's actually a specific tomorrow. Tomorrow, 5 years, 10 years from now, of this market taking off. That's way too early to make a venture investment right now. The company is going to be dead and not be able to survive by the time that the market adopts the take-off moment phase and Hamilton's wording arrives. You want, at the early stage, to be investing in a company like a tick before the take-off phase, and that's hard. 

Ben: In the Peter Thiel parlance, From Zero to One, you want to be investing when the founder knows a secret and you, the investor, agree that secret is indicative of a much larger trend that's about to happen.

David: Yeah, keyword there being—about to happen. This is really hard because it's so easy to get deluded. Not necessarily intentionally or fraudulently, but get diluted one way or the other into thinking that—and the famous Paul Graham phrase that a lot of things that become significant look like toys. This is just a toy. This isn't a significant market or this isn't a significant problem like Twitch. Video game streaming, who's going to watch that? It looks like a toy. Well, it turns out online video games were about to blow up.

Ben: Here's what makes that hard is most things that look like a toy are a toy. It is both a necessary precondition that it needs to sort of look like a toy, especially if you're going for a low-end disruption type investment. But also, if it looks like a toy, it just probably is. 

David: And it's equally easy to get fooled on the other end of the spectrum of—I think about, and I was guilty of this too, several years ago—VR adoption. This is 2015, 2016, everybody thought VR was a tick before the takeoff phase in the market. This is going to happen.

Well, it didn't happen and so then you were too early making those investments. Now actually may be a really good time to be making those investments. They're out of favor. There's a major catalyst for adoption with coronavirus and shelter in place. We'll see, but point being, we're not here to talk about VR. This is actually very easy to get the mechanics right, but very hard to get the answers right here.

Ben: Right. If you're a founder, know that all of this is swirling in the investors head. If they've taken the bait, they're excited enough to dig in on your company, and then they're trying to think about, okay, what does the road look like from here? To figure out if I should invest and then to actually get it over the line at my partnership to make this investment?

David: Yup. At least on the kind of market dimension. Now, let's talk about diligence or digging in on the you dimension if you're on the entrepreneur in the founding team dimension. Founder or entrepreneur diligence. From the VC’s perspective, this is also one where the mechanics are pretty easy, but the art is pretty difficult. 

The mechanics of this are usually, what you'll do first is either you—as the person, the investor within the venture firm—or other people at your firm will know some people who've worked with these founders before or second degree connected somehow. 

You'll just reach out to them and be like, hey, so-and-so, was she great is a good common question. That'll be sort of your first round, and then maybe you'll also dig up some other people deeper in the founders past who've worked with them or know them in some dimension. Then you get on the phone with them or text with them and hear what they have to say.

I'll never forget. I remember Elad Gil has talked about this a lot—who's a great angel investor—that when you first start out in VC, you tend to take those answers at face value. And then he said he found that he would do some of these references or people he'd worked with and knew would start companies. They were just mediocre employees at previous companies he'd worked at and he'd pass on them because they're not that great, not that strong, or whatever. But then they build these great companies. 

He started thinking about it and realized that actually, the traits that make a really good employee are not necessarily the traits of a person that makes a good founder.

Ben: Yeah, and of course, it depends, which is going to be the frustrating theme of this episode. Like anything else, if they were a kickass VP, there are many examples of a kickass VP at some company leaving and then becoming a kickass founder and CEO of another company.

David: But there are also many counterexamples.

Ben: Right. Judgment comes into play here, but your point is the right one to take, which is use this as data, not as a religion.

David: Yup. This is overly simplistic, but I tend to think if what you hear from people is like, oh, so-and-so was a great employee, really got stuff done. One of my most trusted lieutenants. I could give her/him anything and she would just go get it done. That sounds really good and it may be good. That person may be a good founder, but may not be. 

Another thing and I've heard this before, these are pulled from my own experience of a quote about somebody of, someone so supersmart honestly wasn't that great of an employee, though. Worked for me on some projects that he really cared about, knocked it out of the park. It was just really clear when he didn't care about things and couldn't motivate him to get anything done.

Ben: Sounds like a great founder, actually. 

David: Yeah, exactly. Maybe not somebody you'd want to hire, but that actually sounds like a really great founder.

Ben: All right, as long as there is founder-market fit there and they are working on the right thing, that is their splinter in their mind they can't shake then, yeah, that is exactly the right kind of reference you want.

David: Ben, I think you had a couple of good questions in here. You mentioned founder-market fit. We'll come back to that in a second.

Ben: My two favorite questions are, first of all, front of sheet references are almost worthless. If anybody ever gives you like, hey, you should really talk to someone. They were my old boss. Great, do the call, ask your questions, but take it with much more of a grain of salt than someone that you were able to network to and has more of a relationship potentially with you than the person that you reference checking.

David: This is important for entrepreneurs too. Some firms, some investors, definitely will ask you for references during a fundraising process. A lot won't, though. Just because they don't ask you doesn't mean they're not doing them. You should be paranoid and assume that they are being done behind your back.

Ben: Yeah, and obviously if you're an investor here, use good judgment. If somebody is thinking about starting a company, it's very early and they just took a meeting with you, but actually they work at this other company. You don't call their boss.

David: Yeah, that's a no-no. But you might call their previous boss at their previous company.

Ben: Yeah, be sensitive if people are currently employed. But my two favorite questions are, if you're talking to someone, ask them directly. If you could start a company and pick only one person that you ever worked with to be your co-founder, would so-and-so be this person?

It doesn't give you a perfect indicator because it might be the wrong fit with that person, it might be a duplicate of skill sets, or whatever. But forcing that, hey, I have one bullet to use here, and frequently people make one investment per year.

If you have a five-person partnership and you're investing in about five companies per year out of your fund or leading five deals, it kind of works out that you might do one, maybe two investments per year. This is like, hey, I'm about to do the thing that I do once a year. Should I spend it on this company? My takeaway has been giving that question a ton of gravitas. Is this the one very best person you would start a company with—brings a lot of clarity in the answers.

David: I hope you ask that absolute follow up that any investor should ask to that question. It's such a great question, which is whether that person is the person that they would choose or not. Who is the next person you would start a company with and then go call that person? This is back to our sourcing episode.

Ben: Hey, have you ever thought about starting a company? The second question is just ask it instead of as a co-founder, but as an investor. You say, hey, if you can invest $25,000 of your own money in a startup founded by any one person in the world that you've worked with, would this be the one?

You could even ask it more directly, which is like, are you interested in investing in this company? The round size is about $25,000 per angel. Would you put money in? Which is a deeply uncomfortable question, especially when you leave it in silence there and it forces a lot of honesty.

David: This will come back up in a minute with customer and market diligence. People will say lots of things, but their behavior is reflected most truly in their financial decisions. Okay, yeah, there's $25,000 available. Would you put money in? That is a great way to get a very direct answer out of somebody.

Ben: Yeah. If you want to, you can even dress it up more like, hey we're leaning in. I think we would probably do it if you would co-invest with us for about $25,000. Would that be interesting for you? Make it, hey, you're making our decision. And even if that's ultimately not going to be true, it gets to the truth.

David: Ben, you mentioned earlier, founder-market fit, and I think that's the other key dimension of looking at the team as an investor, especially the early stages. There are lots of smart people out there. There are lots of good business ideas, but the Venn diagram intersection of those two is actually rarer than you would think. What's the reason why this team, no matter how smart and talented they are, is going to be successful at this thing? 

This is also something where you can get fooled both ways. Elon Musk had never built rockets before, but he had this maniacal obsession about it that was literally going to drive him and his family to the brink of bankruptcy to do it. That's a pretty good founder-market fit. Likewise, there could be people who have been steeped their whole life in something, but they've just lost their passion for it. They're just doing a startup because it seems like the right thing to do. This is also hard to get to the bottom of it.

Ben: Yeah. I've been thinking a lot about founder-market fit and what it means because you're right. What I don't think it means is this person has done this thing before so they will do it again. Because a lot has changed in the world since they previously did it. And what I do think it means is this person is incredibly passionate about this such that when there are bad days in the company, of which there will be a lot, the idea that they're running it can get them through this. 

When there are changes in the industry that cause strife for the company, this person's motivated enough about the mission that they're on, that they want to persevere through those industry changes. Also, the last piece is, is this person well suited for this business model? If this thing is an enterprise sales type company, is there a CEO who understands that go to market motion is going to be good at interfacing with those customers? 

And obviously, there's ways to augment that. But there are some non-starter type founder-market fit things where it's just clear that if you're creating the next great social app, then the person leading the company probably needs to be a product visionary. And if you're just like a great enterprise salesperson, it's probably actually not great founder-market fit. There are obvious rules of thumb you can use. But then once you get into the Elon and rockets area, we’re very clearly not saying someone who has done this exact thing before.

David: This also doesn't always work there. Hopefully, as it is evident through this whole series, there are no hard and fast rules about anything in venture. A good test for this, especially the early stages, is if you look at what the founding team has been doing, by the time they're raising money, they've been crystalizing on an idea, at least for a little while and gelling his team together.

What have they actually been doing? Are they working on the product? Are they getting an MVP out there? Are they steeped in what's going on? Or are they thinking about choosing a name? Are they deciding what they want their culture to be? Are they creating a logo? One of those things that make me think—

Ben: The window dressing around startups is what you're— 

David: Exactly. One of those things makes me think you're obsessed with the problem and you literally just can't keep yourself from working on it. That's good. Another one of those things makes me think you just want to start a startup, and that's usually not so good.

Ben: Yeah, it's a good litmus test.

David: Okay, customer and user calls are the last real section that we'll talk about in this digging and diligence process. This is probably less applicable at the seed stage because there usually is no product, users, or customers yet—although you can still be talking to potential users and customers—and you should. 

But what I always think about in this stage is a lesson I learned when I interned at Meritech, my summer in business school. Meritech is fantastic. One of the (if not) best growth stage venture firms out there. They did a lot of customer diligence calls when they were investing. This would be Series C, Series D, Series E, real companies, real revenue, and real customer bases. They always talk about looking for the Tableau 10 in a customer diligence call, and they had invested in a great company Tableau. 

Rob Ward, who had led that investment at Meritech and is just a wonderful investor, he would always say that when he did the Tableau customer diligence calls, the people he talked to weren't just saying, yeah, this is a really helpful product. It solves the problem for me. He was like, they were literally trying to come through the phone, beat me over the head, and tell me that this was the best thing that they had ever used. It was so far ahead of the competition, and I would be a complete fool not to invest in them.

He says, at least as of 2013 when I was working with them, he'd never heard that again. But that was always what he was looking for.

Ben: It's a tall order. I will say one thread you're probably thinking, as we keep going through this, is each one of these things seem like a 1 out of a 10 or 1 out of 100 chance of it being true. And when you stack all these things on top of each other, like people know how to multiply, you’ll mostly pass. That's mostly the business. Because sure, you can get through without all of these things being perfect, but most of them have to be there. Otherwise, it's a fatal flaw for the company.

David: Yup. What's hard about customer diligence calls? Again at the growth stage, that's pretty straightforward. At the stage the Meritech is investing, you'd better damn well be hearing those 9s or 10s or the product just isn't solving that much of a need for customers. But at the early stages, you can get a lot of false positives and false negatives here. So many examples I can think of. 

It's related to what we were talking to with market diligence of something that may look like a toy, the product's not totally polished yet, or there's some key feature that the team is about to ship that is going to make a difference. You really need to use your judgment and a little bit of imagination here.

I always think the important thing to be listening for with early stage companies when you're talking to customers is not this particular solution that the company is providing to the customer. But what the problem is that the customer has like how deep is the problem? If the problem is deep, then the company and the product—if they're smart, good entrepreneurs—they can root around and they can figure out the right solution to address a deep problem. If the problem is not that deep, even if they do that, it's just not going to be that significant.

Ben: That's a great point. I hadn't thought about that.

David: Generally, the best way to do that is to try as much as possible to think about—this is particularly for enterprise and for transactional companies—it in terms of monetary terms. If you're an enterprise service, how much revenue could you make with whatever category of thing this company is purporting to provide to you? Or conversely, how much revenue are you losing?

You could also think about how much cost you could save, but I always think revenue is the big driver here. It's hard to build big companies saving costs.

Ben: You can do it, but there's asymmetric upside in revenue. You can only reduce costs so much, but you can increase revenue infinitely. 

David: Yup, and then interestingly, this works with consumer transactional business too and particularly marketplaces. I'll never forget pretty early in Rover’s lifetime as a company, this would have been a year and a half, two years in, maybe I'm getting the dates wrong. But we had a seeder on the platform that made over $100,000. 

It was making at a run rate of around $100,000 in fees. Literally, this was their livelihood, and that was such a key moment. And then when Rover went out to raise the next round, that was a big part of the fundraising story. This might have been the B, probably the B. It was like, hey, here are people who are actually transitioning their livelihoods onto this platform. This is very powerful.

Ben: Yeah, it's a great point. There's an interesting [...] of things there around like. Are all of these gig economy things? Is it actually people doing gigs or is it actually the professionalization of the supply side, which I think has been an interesting knock-on the share economy broadly. This isn't gig work or gap time. People are just taking jobs working for these companies. But in this particular instance, what you’re illustrating is they had solved a real problem for that supply side. That person was able to make it their job.

David: Yup, totally. Who is doing all of these “work” in the investment process at the venture firm? Also a good question—varies wildly by the firm. Some firms, the partner or the general partner, whoever is “leading the investment,” is doing all of this work themselves. Some firms don't even have teams underneath those people.

Sometimes those people are not doing much work at all, and it's all being outsourced to an associate or a principal, or maybe an associate and a principal—depending on how big and significant the deal is for the firm. 

I would say at most firms though generally tend to take a team model like an investment team model so they'll be a partner or a GP who is leading the deal and a principal or associate working with them, and the two of them usually do this together. If you're an associate at a VC firm, most of the time you should expect to be doing a lot of this work alongside a partner.

Ben: Yup, and the more old school firms, this is usually structured in a way where there's always the same associate map to the same partner, their sort of sponsor. A more common model has recently been sort of a bullpen of associates in principles that work with different partners depending on their interest level and expertise in a certain area.

David: This is one of the best parts of the venture model. And this is where a lot of the apprenticeship model and knowledge gets transferred is through the active practicing of doing these things together. 

Ben: Frankly, this is the fun part. It’s a lot of work, but this is when you really develop a lot of your skills and pattern matching. This is when you grow spidey senses about what the fatal flaw in a business is such that you can hear it in a first meeting. Because you’ve looked at a similar business model in a different space before, you understand where something fell down in their financial model, and what made it hard for them.

If you’ve ever been a founder in a meeting where a VC somehow within 10 minutes of you starting to talk about your company, zeroed in on the hardest possible question to answer, years and years and years of doing this is why. 

David: It’s not because they’re that smart. Maybe they are that smart. 

Ben: And you also don’t have to bring it up in a way that shows, oh look how smart I am. But it does save everyone time if you can get to that thing more quickly.

David: All of that is the work. I would categorize that as that is everything that happens between you or whatever partner you’re working with at the VC decide we’re interested in this up until the decision-making moment. What is the decision-making moment?

Ben: Let’s talk about what a partnership is for a moment. Importantly, how it’s different than what a company is. A corporation has a CEO. Ultimately, the book stops with them. And if they are not doing their job well, they get replaced by the board. Everyone knows how a company works. 

With a partnership, how on earth does a group of five, six, seven, eight people make a decision? Who’s the decider? How does that possibly happen? You can go through as many of these pitches, processes, separate meetings, preparing memos, and everything as you possibly can, but who decides?

David: My wife, Jenny, used to have this analogy that was a joke, but like all jokes, there’s a lot of truth in it. She would say that VC firms are like loose affiliations of warlords. Each warlord is an individual warlord, but they’ve banded together to have more territory. That I think is at least closer to the truth of an investment partnership than a corporation. 

Ben: Totally. If you trace back the very earliest partnerships were literally consolidating their back offices and bringing their individual Rolodexes to find synergy in consolidating and reducing costs. Over time, of course, this has turned into, rather than a defensive—how do we save cost, more of an offensive—how do we build a big brand together or how do we build an enduring institution? But the original thing of partners who all co-own a thing together and make decisions in a group format, that is still remnant. 

David: Yup. Pre-Sequoia and pre-Kleiner Perkins who had started right around the same time. It mostly was people investing their own money. It was their partnering together to invest their own money together. Companies, it was only with that modern era that started in the mid-70s of raising money from limited partners who weren’t making the decisions, but were just providing the capital became commonplace. 

Ben: This creates all sorts of frustrations. The fact that it’s got those roots but has evolved into a professionalized job class. When people say things like, what does a career progression look like at my firm? If you were to ask that question in 1971, it would be like, what? There’s five of us here investing our money, we hired you to help. What do you mean by career progression? 

Now, it’s like, I’ve joined this wonderful 80-person organization that has this brand, these benefits, and I expect to grow up here over the next 20 years. 

David: A whole team of operational folks that help our portfolio companies. All of this stuff. I’m glad you brought that up because that is going to be a big theme, the fact that these are jobs now instead of principal capital that’s going to come up at the end of the episode. 

Most firms, this decision-making crucible happens in a “partner meeting,” which used to happen only on Mondays for some reason across the entire industry. 

Ben: It’s still by far the most common.

David: Yeah. I don’t even know anymore. I think it’s all over the place. Some firms do multiple partner meetings a week, some firms do ad hoc partner meetings, some firms do partner meetings only by sector group or geography. It really depends. If you’re an entrepreneur raising money, you’re at the end, you’re at this point of the process, the partner meeting cycle, firms have generally realized they have to be so responsive and fast-acting in these moments that the partner meetings happen in an ad hoc fashion—especially over Zoom now. 

Ben: Yup, fair point. 

David: But regardless, almost always, this is where the decision gets made. Typically, what happens is the CEO of the company or the founding team all together will present to the whole firm, either to the general partners of the firm, or more often everybody who works at the firm. It’s almost like a gladiator-style meeting with an audience. Some of these meetings, you can be an entrepreneur going up and pitching your company in a very scripted 30–45-minute pitch to 30 or 40 people, most of them you’ve never met before. 

Ben: It’s wild how many people can cram into these conference rooms.

David: You have no idea who they are, you’ve never met them. And your whole interaction with the firm—up into this point—has been a very personal relationship building exercise with one, two, or maybe a couple more people, and then all of a sudden, you’re put in front of the gauntlet. 

Ben: And to stack the toughness on top of that, after this person gracefully introduces you to the firm and stands up and says a little thing about we’re really excited to have so and so and in and they meet all the people—

David: This person being your deal lead.

Ben: Yeah, deal lead, deal sponsor, or the GP that you might work with. Hopefully, your potential future board member. They’re usually the quietest. As an entrepreneur, you’re like, wait, wait, wait, this person has been the person I have the best relationship with here. But that person’s job at this point is to give everyone else exposure to the opportunity and not monopolize the conversation with their own questions that theoretically they should’ve already asked all the way, probably even written down on a deal memo.

David: Yeah. There are lots of pontificating that happens from all sorts of comers in this meeting. As an aside, switching over for a minute to the entrepreneur’s perspective instead of the investor’s perspective, one thing I always say and tell people—especially now that I’m not currently affiliated with a venture firm per se is—you are in control. Do the whole process. You are in control. But it can be so nerve-wracking. You get up in front of a bunch of gladiators. You got to remember, these people should be lucky to invest in you. Don’t let them control the meeting. 

Ben: It sure feels like they’re in control because you’re in their office, it’s all of them there. They literally carve out time in their calendar for this to happen multiple times per week in the exact same way. It feels like, okay cool, I guess I’ll just slot into the thing that they do.

We’re going to talk a lot about this, but investing in the earliest stages is about non-consensus bets. Your job is to not be like everyone else and say why you are very different than all the previous startups. 

David: Such a good point. Flipping back to the behind the scenes investor perspective here—decision making. One thing we should’ve said typically before the meeting happens. Either a couple of days before, more often at midnight the night before, the deal team will send an investment memo to the rest of the firm to get them up to speed on this investment consideration that they’re going to make in this partner meeting. Typically tomorrow or five hours from then. 

That memo is some form of distillation of all the findings in the diligence doing work section that we were talking about before, as well as a recommendation. The recommendation is always, we should do the deal because if you didn’t want to do the deal, why are you bringing it in front?

Ben: But it frequently has recommended terms or structure as well. 

David: Right. Or we think this is really interesting. Here are some questions we have. These are key things that we want the whole group’s on from the partner meeting. This form, back in the old school days, used to be a Word doc that we get mailed around or a PDF. These days, it could just be an email, could be a Google Sheet.

Ben: The earlier it is in someone’s career as an associate or a principal, the more likely it is to be a perfectly filled-in template that the firm uses. The opposite side of that spectrum is a not well-formed email that has a few really compelling points about why this person or this opportunity is top-notch. I’ve even seen it be the case that someone says after they already commit after a VC already commits and says, we’re in. To say, can you obviously send me your deck and then send me a few more pieces of information that I’ll need for creating the memo. 

David: This runs the gamut. Why does this happen? Who does junior VCs typically end up writing a beautifully crafted, well-formatted memo with brilliant thought and incisive questions in it?

Ben: The right thing is bolded; the right thing is italicized.

David: And senior people maybe send an email. Because the reality is this doesn’t really matter. This is a check the box kind of thing. 

Ben: I’ll push back on that.

David: Wait, wait, wait. I guess you should, and in some firms it does. It really depends on the partnership. But in a typical bigger firm, everybody’s got their own stuff that they’re focusing on. It doesn’t matter because people, by and large, aren’t going to read it. Or if they are going to read it, they’re going to skim it. They’re not going to read this beautifully crafted 10-page memo in great detail. The more important is the email, here is why this is compelling, here is why we’re bringing them in, pay attention tomorrow. 

Ben: Okay, I have two thoughts. One is it’s the same reason why board decks matter. They matter less for the board and more for the entrepreneur to clarify their thinking. It’s for the deal team to really zero in on what is the crux of this investment? What are the key things that could make this company enormous versus what are the biggest risks? If it fails, why is it going to fail? That—if it fails, why—is a common part of the investment memo. It can have plenty of bullet points in there and the deal can still get across the table. 

The second thing I’ll say is training. The reason why those senior partner emails can be a few sentences is because they’ve done this so many times that they know what the important parts are. And absent actually doing this and going through the machinations, you don’t develop that spider-sense. 

David: Here’s another good point too related to that. It’s not just training, but it’s also this concept of juice. How much juice does the deal lead have in the firm? If you’re a senior partner, maybe a founder in a big firm, who’s really going to tell you no? By juice I mean influence. You could phrase this as you can get away with doing less, but you can focus on other things.

Whereas if you are a younger, more junior partner, maybe this is one of the first couple investments you’re leading, you’re really going to have to build your case internally with all the senior partners about why they should let you do this.

Ben: Yup. Advice for junior folks of VC firms out there. A very common way that something gets over the line, which actually is very similar to big companies, is you have the meeting individually five times before the meeting. 

David: Oh my God. It took me years to learn this. Let’s underscore this again. You’re a junior VC at a firm. No one is going to tell you this when you come in. Or at least, nobody did for me. Yet you can’t just write the memo, hit send, go to the partner meeting, make some nice points, and then expect everybody to support you. 

Ben: Have the first time the vast majority of the partners meet the person be in the partner meeting. 

David: No. You need to be doing some Barack Obama style community organizing.

Ben: Coalition building.

David: Coalition building well before the decision point happens if you want to get this done. Obviously, with all the usual caveats that every firm is different. If you find yourself as an associate or principal in a large firm with these types of dynamics, you would do well to remember that for your first few deals. 

Ben: Generally, if you’re a principal, you’ll figure this out. 

David: Yup, totally. 

Ben: Also interesting for entrepreneurs, as you are sizing the person across the table from you when you’re pitching them, deciding, huh, do I want to spend a whole crap ton of time going through diligence? And then potentially ending up with them as an investment partner. Do I think they have figured this out? Do I think that they actually can get something over the line in their firm, or is this a waste of my time?

David: Absolutely. That is such a good point. Because this will take a lot of your time as an entrepreneur. 

Ben: Before we continue, people often ask me, what does the process look like from here after the very first meeting? It’s tough. The right answer is sometimes, we will have one more meeting and it will be the partner meeting. There are other times that middle of the road is probably two or three meetings before the partner meeting where I just continue to bring in more and more and more people at each one. Other times, even a very senior partner will say, I’m going to have you meet with every single one of my partners before we do a meeting together. 

You could have six, seven meetings. If you get that many meetings in, it’s probably pretty likely to happen. It can be a long process, but it’s almost like you shouldn’t dread that process because the deeper you get in it, the more likely it is to tip. 

David: I think yes, that’s actually true. What’s really interesting, we’ll talk about this in a second, is all of this is wholly dependent on the deal dynamics—supply and demand. Every market is supply and demand. 

The more people who are interested and the more competition there is for a deal, the faster it will move, and the more likely it is that you will get yeses from everyone versus when there’s less competition, then there’s no reason then. VCs can take as long as they want, and they can have seven meetings. Then they can still say at the end of it, hm, you know we’re not ready yet. Why don’t we talk again in three months? Whereas if it’s either now or never, then they’re going to have to make a decision. 

Ben: Such a freaking art. 

David: The lesson there for me from an entrepreneur perspective—and VCs too when you’re raising money for a firm, which we’ll talk about fundraising later in this series—is it’s a numbers game. Your job is to fill the top of the funnel with as many people as you can. Way more people than you think you should. 

Ben: Yup. 

David: The partner pitch by the entrepreneur has ended. These poor folks are shepherded out of the room—often unceremoniously or just booted out of the Zoom room. And then a discussion happens. What happens next? This definitely varies hugely by firm. Some firms do an actual vote, sometimes it’s just the partner’s vote, or sometimes it’s the whole firm's votes. It could be open voting where everybody announces their vote. 

I particularly like blind voting where some version of either digitally or physically you write your vote 1 through 10 of how excited you are about the investment on a piece of paper. Everybody does that at once, you don’t influence each other. Then flip it over and then you explain your vote. 

There are also firms out there that don’t vote at all. It’s just qualitative feedback, it’s the deal lead’s decision. Those tend to be smaller types of partnerships that operate that way. 

Ben: And we should say too, there is every different way to vote on this. There are some firms that require unanimous agreement. Some firms require a majority. There are some firms that have a pound the table, which is look, if the deal lead is pounding the table and saying, I’m staking my whole reputation on this thing and we’re going for it, then we’re going it. There are some firms that operate the veto framework, where you get a certain number of vetoes per year or per fund. Anybody can veto a deal and then it’s dead. 

Usually, this is not public, how this decision-making process happens. It’s considered a proprietary part of the firm. Some firms will use it as a competitive edge to show transparency and say this is how we make decisions at the firm and tell entrepreneurs that. But you really don’t know exactly how the decision gets made.

David: Yeah. Usually, there are multiple dynamics going on. If somebody tells you how they make decisions, there is a good chance that actually how things are really, really decided behind the scenes aren’t quite that. You should always be skeptical. Working at a venture firm too, it can be hard and take a long time to suss this out. Even working within the firm of what are the real power dynamics and how the decisions get made?

Usually, the outcome of all of this discussion is typically, if the firm wants to invest, usually these days a verbal offer that same day, often that same hour to the entrepreneurs of the terms at which the firm would be willing to invest. Sometimes it’s a written term sheet. But a lot of terms these days to go the verbal offer out to design suss out where who else is interested, what other terms are coming in before they formalize it with a written offer?

Ben: The verbal offer often won’t be specific. Hey, we really want to do this. We’re thinking something like this.

David: We’re thinking we do $5–$6 million of a $10 million round at a 30–35 post or whatever. Something like that. Those would be bad terms. 

David: And also, depending on how the round shapes up and how many people are interested, another thing that happens almost all the time is the amount of capital raised changes. It’s more common that the capital raise will go up versus necessarily the amount of the company that you’re selling going down. The valuation will go up, but the capital amount raised will go up too (at least these days). 

That’s the end of the formal internal decision-making process for a firm. But that is just the point at which the battle plan meets the enemy.

Ben: Right. There’s a certain amount of latitude given to the deal lead to say, okay, we’re supportive. These are the terms that feel right. Now go win within some parameters. Those parameters can be these are the terms, come back to us if it’s any different or we’re not doing it. Or it could be, hey, we trust you implicitly, go get the best deal. Or whatever the terms are they are, and it ranges from everything in between depending on the partnership.

David: Totally. But I will say it’s very, very rare—having seen lots of deals get done in my day now—that the deal gets done with the terms that are initially proposed by the VC firm. Most of the time, that is because of competition real or perceived. But what’s super important to keep in mind—and very, very hard both as an investor and as an entrepreneur—is psychology and behavioral economics play enormous roles in everything that happens after this. 

Like we mentioned earlier, the incentive of a venture firm—no matter how nice the people are, well-intentioned they are, great, or whatever—their incentive—and if you’re a venture investor, you’re incentive—is for the entrepreneurs you’re talking to to be talking to as few people as possible and have as few options except you as possible. We talked about in sourcing, the “proprietary deal flow.” Why is proprietary deal flow great? This is why proprietary deal flow is great. 

As an entrepreneur, you want the opposite. You want to be talking to as many people and have as lowest supply of dollars available in your round as possible.

Ben: I will say, I have seen a handful of deals where this just doesn’t exist at all. You have trusted the relationship between the general partner and company founder and CEO and maybe work together before. In both cases, the entrepreneur just says, I want to work with you. I trust you to give me fair terms. I don’t want to go run this whole roadshow. If you feel good about what I’m working on, then let’s figure something out relatively quickly here. And you basically can just skip all of this. But that typically requires a pre-existing relationship.

David: Exactly. It requires a high degree of trust, either in a pre-existing relationship or in a belief and understanding that the person on the other side of the table is playing the long game here. As a venture investor, why would you not take advantage of that? You would not take advantage of that if you believe that your reputation and what that entrepreneur is going to say about you, especially when that entrepreneur finds out what market is for rounds like they are doing, how they’re going to feel, and what they’re going to say. If you believe that that is more important than this particular deal, then you’re incentivized to give market-ish terms.

But I think an important point to say here, for both sides, is that this is a transaction that’s happening and a market for startup equity. Relationships are very, very important. But why are these relationships being built on both sides? It’s because both sides want an edge on the market. 

As an entrepreneur, especially if you’re a first-time entrepreneur, your head can start swimming as you go through a process. All these people, they seem so great. They seem like I would really love to be in a relationship with them. But you also want to keep in mind what their incentives are. 

Ben: There are so many different things to optimize for. One very reasonable one is someone who has been in this racket long enough that they’re just sick and tired of the BS, and that they want to cut out the crap as much as you do. That can both be marketing speak or it can be the truth.

David: Both can be true. Even in the same person. What’s a specific take away from this is—I don’t know if you have, Ben—I have never seen an investor walk away from terms that they’ve offered because the entrepreneur wants to negotiate. It can be a little intimidating sometimes, especially for first-time entrepreneurs of I’ve received this offer from a firm. I don’t know especially if I don’t have that many offers, I’m worried about losing this particular offer.

If somebody wants to do something and wants to do it badly enough they’re sticking their internal reputation within the firm to stick their neck out and say, I’m going to leave this deal. You saying, oh, I have some ass. Here is how I would like to change this, negotiate on price or whatever a little bit. You might not be able to get what you want, but nobody’s going to walk just by virtue of you saying I want to negotiate. 

Ben: Yeah. That’s true within limits. Certainly, VCs have walked away when an entrepreneur comes back and says I have a term sheet for triple the valuation. I do want to work with you though, can I negotiate up? You’re like, this is a completely different thing than I prepared my partners for.

David: Right. This is where it’s a delicate dance. The point I was making was you have to be respectful of the other side. Remember too, this is a relationship you’re entering into and negotiating good faith. Coming back with a sledgehammer like that is going to get somebody to walk. Just the virtue of negotiating itself, if anything, VCs, while they may grumble at the moment, they’re going to want you to negotiate because they’re also thinking about how are you going to do when you raise your next round and I’m on your side of the table.

Ben: Yeah. Are you going to be a good negotiator on my behalf?

David: Yup, exactly, exactly.

Ben: Plenty of times, it happens that an investor will invest in a great company on shitty terms. But almost never will it happen that an investor decides that they should invest in a [...] company because there are great terms. That is a funny fallacy for anybody who’s getting into this for the first time. They are like, I don’t know, it’s like a two [...]. You’re like, yeah, I know—for a reason. 

It’s important to recognize that people are willing to flex on price once they’ve decided it’s a great company. But rarely do someone flex on thinking something is a great company because the price is so good. 

David: Particularly at the early stage. As you get more into the growth stage, then price does become a lot more important. 

Ben: For sure. Because the upside potential is massively capped. 

David: Totally. I have a great close friend from business school who’s a great growth investor at a big firm now. I’ll always remember talking with him about this shortly after we graduated and I was doing early stage investing, he was doing growth. His firm does both early and growth. He said, “You know, it’s sort of frustrating in some of these investment decision discussions with our partnership. Because the partnership is early and growth folks all together. The early people, the only question they ask is do you have conviction in this company?” 

That makes sense at the early stage. But once you get to the growth stage and you’re talking about hundreds of millions or billions of dollars valuation, it’s actually a different question you need to ask. Do you have conviction in this company at this price? That is a slightly different question to ask, which brings up, when you’re in the seat as an investor, you’re leading a deal to the partnership through this crucible, especially if you’re relatively junior. 

You’re balancing three things. You’re balancing your conviction in the company. And that translates to will this company be successful and successful at a scale at a significance that will matter to me, to my career, and to this firm. You’re balancing that versus the price of the company, which while it matters less at the early stages, it does still matter. Like you were saying, Ben, if an entrepreneur comes back and says, I really like you but I want triple the valuation.

Ben: The valuation matters a lot more these days, at the early stage, than it used to because early stage can mean such a wide range. Seed rounds used to get done at $3 million and $4 million valuations. Maybe if it were crazy, a $5 million valuation. And now seed rounds get done anywhere from $4 million or $5 million to $40 million. Sometimes even higher. 

Let me underscore why that’s really, really important. Because when you go from $4 million to  $40 million, then the multiple you can get is literally 10 times less. Your cost basis has gone up 10x. Whatever the company’s eventual outcome was going to be, if you were going to get maybe that home run 50x. Now, you’re only getting a 5x. It is way different. 

David: Yeah. That is certainly, certainly true and important. I think Calacanis made this point either on the main show. I think it might have been the LP Show he did with us. We’ll get into this when we talk about portfolio construction and VC fundamentals. The bigger issue is, as valuation goes up, if you’re trying to get ownership in these companies, your check size goes up. 

That doesn’t matter if you’re a billion-dollar multistage fund at the seed stage. But if you’re an early seed [...] or seed stage fund, and instead of writing a $1.2 million check you’re writing a $3.6 million check, that means you just used three investment slots in your portfolio on this one company. That’s two fewer companies you get to invest in this fund or for you as an individual in this year or in this set of years. That has a real opportunity cost. 

Ben: Not only for the direct opportunity cost of I can’t invest in those two companies, but it affects your portfolio construction. Where if you’re already squeezing it pretty thin and saying, we’re going to do 20 companies out of this fund or 25 companies out of this fund. And you do this 2, 3, or 4 times, suddenly you’re only doing 10, 12, or 14 companies, and you’re not diversified enough, especially for this very early stage in order to maximize your chances of having 1 fund returner. 

David: Those are the two obvious things that you’re balancing conviction and price, otherwise phrased as risk and return. Price being risk and potential return being your conviction. They’re actually a really, really important third dimension that you’re balancing as you’re navigating these processes as an investor within a firm, and that’s your reputation. Not only your reputation and the firm’s reputation externally with entrepreneurs, with other firms, with co-investors, et cetera. But brass tacks, your reputation as an individual within your firm. 

Didn’t Santi say on our Zoom episode that when he was leading the Zoom investment and he was still a pretty young VC at Emergence at that time? It was the largest check they’d ever written. The partners took him aside and they said, “Hey, Santi, we’re supportive of this deal, but just so you know, you’re risking your career on this.” That’s heavy.

Ben: Yeah. This doesn’t work out, you’re not doing any more deals here. 

David: Right. We’re going to come back to this in one second. The goal of our fundamentals of VC series is not just to talk about all of this is to expose the what, the how, but let’s talk about what this means. You’re an investor, what do you do? How do you manage this very stressful process? I’ve been through it a lot, you’ve been through it a lot, Ben. What do you do here? 

At the end of the day, related to what we’re just saying, the two questions you have to ask yourself if you’re going to advocate for an investment is one, is this subjectively good investment at this price and structure at which we can invest in this company? And then the second is, what is the impact that making this investment will have on my career?

Sometimes those answers are aligned and sometimes they’re not. Let’s take an example. You’re a newly minted principal at a VC firm, and you’ve just gotten your first check-writing privileges. You’re doing within your first five investments. What are you really, really trying to do? At the end of the day, you’re trying to be a good investor or you wouldn’t have gotten to this point mid-stage in your career and still be loving wanting to do this, but you’re also trying to get promoted. And you’re also really trying not to get fired. 

How do you get promoted? Certainly, a big win. You invest in Zoom early, that’s going to get you promoted for sure. But that’s accompanied by a big risk too. Another strategy would be to get quick wins and several of them with lower risk. What are quick wins going to be for you? 

They’re going to be companies that are going to raise another round relatively quickly that you’re going to get marked up on, that you’re going to look good, and that your co-investors who are going to come in are going to be very well respected co-investors. Either you’re coming in alongside or coming in after you. That’s going to make you look really good. 

Ben, you mentioned right non-consensus bets versus right consensus bets. You can maybe start to see here that…

Ben: There is an incentive for anyone who wants to be promoted to make right consensus bets. 

David: Right. Actually, pretty strong incentive not to make non-consensus bets. I think it was Howard Marks who coined this analogy and then Andy Rachleff popularized it. It may have been the other way around. If you think about investing as a 2x2 matrix, you can either make investments and be right about the investment, or you can be wrong about the investment. If you’re wrong, you’re just not going to make any money. Full stop. 

But you actually have to be more than right to make real money, real outsize about market returns in investing. You need to be right and non-consensus. Because if you’re right and consensus, the market’s going to be right there with you, and you’re going to earn a relatively market return relative to the whole venture market. But if you’re able to do something that others aren’t and it’s right, that’s when you really make big returns. 

Ben: What you’ve exposed is a flaw in the way this ecosystem has evolved. Let’s take a few things to be fact. One, venture returns are power-law distributed—almost every case. There is no firm that has 3–4xed by generating 3–4x in every single one of their investments. Sure, the growth stage, but not the early stage. 

If we take that to be the truth, then what you have to be doing is every single one of your bets has to be able to return the fund. You shouldn’t be writing a check unless you think that it can be 30, 40, 50, or 100x. If you’re acting purely in the best interest of your investors, that’s the thing to optimize for. What you just pointed out, David, is personally, you have another incentive, and that’s to get these quick markups. 

David: Right. Actually, for a lot of people in the industry—I don’t say this to criticize, it is what it is, but it’s important to know if you’re going into this industry. You’re already in it, or you’re an entrepreneur—a lot of the incentives for people are to make right consensus bets. There’s consensus versus the industry. Do other VCs want to invest? Will it get markups? Will respected people want to invest? There’s also consensus within your firm. If you’re going against your firm.

Ben: Right. What’s a deal I know I can get across the table versus no one here is going to go for this.

David: Right. Nobody’s going to go for this. I’m going to spend all my political capital making this investment because I really believe that it’s going to be non-consensus and right. I’m channeling some Charlie Munger behavioral finance musings here. How is that going to play out? 

Let’s say you are right and you make good money on that investment. You probably won’t get fired. You may even get promoted. Now, in the downside case, I can see it even more clear. If you make investments that are consensus within your firm, where everybody’s supporting you doing it and they don’t work out, you’re probably not going to get fired. You’re going to get a bunch of second chances. 

Ben: Hey, those were good bets. Those were good bets you made there. 

David: Just the market went against you, it’s a wrong timing, or whatever.

Ben: Right. You ran the right process. And just because the results weren’t right, you should be rewarded for running the right process. 

David: But let’s think about the bottom quadrant of the 2x2 matrix. You made a non-consensus wrong bet. You stuck your neck out and you’re wrong. That’s going to be real tough. 

Ben: You said we should go hard in the ICOs. 

David: And people may be right in the long run. A good place to wrap a whole bow around this—and something I’ve been thinking about a lot, still learning on my journey—is what are the lenders really thinking about this? I think it comes back in many cases to your time horizon. That’s a big element to be aware of as an investor of your time horizon for success on a given investment you’re making? 

If you’re trying to get promoted, get the markups, and get the external validation that you’re going to need to advance your career—like we were just talking about—your time horizon is pretty short. You want to be moving up in your career every 18–36 months. That means you need a bunch of companies that are showing this performance within that time frame. 

If you’re willing though—for whatever reason—to extend your time horizon out farther, (as an aside) we should say too, it’s not just individual investors that these dynamics apply to. It’s firms too. New and younger firms, they almost face the same dynamics with their limited partners. They’re trying to prove themselves with their initial funds and then raise subsequent funds.

If you’re willing to extend your time horizon longer, then you can have more patience with these non-consensus bets that might take longer to play out. Maybe not even because of the fundamentals of a company themselves. But if it’s non-consensus and other VCs aren’t going to be hot to finance them like ICOs, I am sure there are some ICOs out there that are great companies that are going to be fundamentally strong, good investments that will have come out from the past few years. 

But there is going to be a winter that you’re going to have to live through as an investor over the next couple of years where nobody else is willing to finance them. 

Ben: In some ways, I don’t want to just point out here is how effed up this whole thing is because I don’t think that’s why we’re doing this. Much like every LP episode, these are the incentives at play. It naturally guides the water to flow in the direction that it flows because there are rocks in certain places. 

All you can do is be aware of them, mitigate the things you don’t want to happen by designing different incentives. If you’re starting a firm or if you’re choosing what firm to raise from, knowing what their incentives are, it just helps you understand better on your journey for the things that you’re trying to optimize for. 

David: Certainly, for entrepreneurs, especially for investors too. The more aware you are of these dynamics, the more you’re just going to better manage your own in psychology and hopefully your decision-making in this process. I think it’s really important. I so wish when I was a young investor that I had understood these dynamics because then I would’ve been able to better say, okay, which companies and why am I really going to put my weight behind. 

And maybe it’s okay to do certain kinds of companies now. And then maybe later, it’s okay and better to then do certain other types of companies. Your career is long.

Ben: As long as you feel you’re acting in the best interest of your investors. 

David: Of course, of course. What’s also really interesting is the past 10, 15 years of the market cycle we’ve been in, it’s not like you’re necessarily doing wrong by your investors by making right consensus bets. You can still do very well in this current environment. 

Ben: Yup. That’s a great point. All right, David, should we bring this one home?

David: Let’s do it. 

Ben: I think a major takeaway here for me—and anyone’s who’s scratching their head in here saying—what did I really glean from this episode? I think the biggest one is every firm is different. A second one is just try and get as much transparency as you can and be okay when someone’s not able to answer transparency. 

If you’re going through the process of pitching a firm, you shouldn’t be aggressive about how many more meetings will it take. Both because that person may not be able to tell you because they’re still formulating in their head what’s the best way if I believe in this to get there over the line. 

But then also, if the question is more like what’s the way that your firm makes decisions, it may not be something that they’re able to really talk about. I think that there is a general awareness that we’re trying to bring to the wide variety of ways that this gets done 

And then on top of this all, just bring general transparency to areas where we see trends that you can pattern match between firms and take as okay, in most cases, this kind of thing is going to happen.

David: Yup. Totally. On the next episode of VC Fundamentals, we’re going to shift gears entirely. Today’s episode was super behind the scenes baseball of venture firms. We’re going to talk about company building. What happens after you write the check? More accurately, after you write the check but before you write the next check.

Ben: All right LPs. Thanks as always for joining us, and we’ll see you next time.

David: We’ll see you next time.