The past decade had been the most significant to tech venture capitalists’ portfolios. The result is driven by extreme growth and user adoption of internet monopolies’ products following an extreme version of the 80/20 principle for value creation.
While some of the investment opportunities in these ‘high-growth’(as Elad Gil puts it) companies were hard to participate for some, others enjoyed the privilege to pass on them and leave their checkbooks in the pocket.
Passing on these 🦄 turned out to be extremely painful for some VC years down the road, missing on hypothetical significant returns for their funds and LPs. Some VC specified on these missed opportunities and have dared to share that with the world. With that in place, I had a chance to look at some of these cases and extract significant patterns for investors passing on investment opportunities for the wrong reasons.
As a learner of the space, I regard these important to recognize when investing and maintaining a healthy investor’s mindset:
Rejecting a startup based on it’s TAM
While looking at TAM(Total addressable market) is extremely important, rejecting a product based on a small/non-existent market could be a severe mistake. That’s because startups building new technology don’t necessarily go after disrupting the existing market but creating a new one, just like the book ‘The Blue ocean strategy’ describes. A great example of this is Uber, which seemed to belong to the limousines market, yet ended up belonging to a broader market. While TAM should not be a reason to say no in my opinion, It’s still an important indicator to consider when choosing an investment for specific stages of capital raise, perhaps for later rounds. The Seed stage bets are the wildest; therefore, TAM is too metrical and can be irrelevant at this point. Valuing a company at an early stage can be referred to as a form of art given the lack of financial indicators to look to evaluate the business. The way i look at it, assessing an early-stage investment, should concentrate more on applied theories of problem-solving, founder’s motivations, backgrounds, and timing.
Not participating because of an “expensive” valuation
In retrospect, almost every acquisition of a valuable company seems cheap. Instagram was sold to FB for $1b a few years ago, and a couple of months ago, Honey was sold to PayPal for $4bn. Sure Instagram seems cheap comparing to Honey, right? Similarly, CTRL-Labs was sold to FB a few months back for $1bn. I already feel like it’s cheap! So in a few years…time will tell.
Neill Brownstein called Apple “outrageously expensive” when his firm(Bessemer) had the chance to invest in the pre-IPO secondary stock at $60 million valuations.
Both at early and later stages, the topic of the valuation has always been a highly controversial one!
In my opinion, looking at a startup valuation at an early stage is extremely tricky, and there’s room for a big spread between VC valuing the same company. While that can be the case for both undervaluing or overvaluing a company, at an early stage, this might not be the concern for an established venture fund. The reason for that being the VC category aims for extreme returns in all cases — every investment is expected to return a high multiple of the capital. Even If a company is valued a $20m higher than a VC thinks at a series A stage, it wouldn’t matter the day this company would exit at $1b two years later. VCs should not try investing “cheap money” because no one can really know what’s precisely reasonable at the time of the investment, and there’s significant room for error. Venture capitalists trade i liquid assets, which priced less efficiently than publicly traded holdings in most cases. For that reason, a VC can still win by getting into the “expensive” rounds.
With that said, VCs must stay cautious in regards to how they value startups in a way that isn’t creating a bubble in the market. Some say we’re already in that stage given the fact some startups nowadays are standard valued at >$20m without having a v1 product in hand — an outrageous valuation compared to previous years. I recommend listening to Harry Stabbings’ podcasts to hear more points of view on that topic.
Passing on a company because a mind has already been made up before
Sometimes, Investors get the chance to invest in a company more than once, even after passing on the opportunity in the past. Yet they end up passing on the same chance again because they already said no before, making a ‘yes’ looking inconsistent with their thesis/mind. That can be a harrowing experience in a case when the company ends up taking off, leaving a deeply hurt ego behind. It’s a mistake not to re-evaluate a company when it gets to a stage of raising more capital. Many things can happen between rounds. Often, worries of the past have already been solved, and the company is at a different place. It’s okay to be wrong, but the worst mistake of all is to make the same mistake twice. Especially when our ego is involved in decision making, mostly unconsciously. An example of someone who learned that lesson is Gary Vee, passing on Uber’s early rounds TWICE. Yet he ended up investing in later rounds. Another good example for an investor that successfully learned from past mistake is Keith Rabois, who passed on investing early in Stripe. That mistake has costed him billions, yet he ended up investing in a later round.
Rejecting an investment based on a company’s potential regulatory difficulties
In the early days, who would’ve thought Airbnb or Uber could overcome inherent regulatory challenges when renting homes to strangers on a nightly basis or letting anyone start his taxi business? The truth is — MANY!
David Cowan passed on PayPal’s Series A round because of its “rookie team 😃” and the potential for a “regulatory nightmare.”
Yet the crazy ones have believed in a simple idea that users would want. This concept is described best as Don Valentine had famously put it — Even if the startup messes it all up, the team still end up winning because the users pull the product out of the startup’s hand so firmly. In other words, there’s a product-market fit. The crazy companies still win regardless of dependency on regulation or other platforms they rely on. Instead of adapting to existing realities, they create their own, because the crowd so actively drives them. Worrying for the bad too often becomes a mistake rather than a wise person’s act.
Similarly, I think this theory can apply as the test of product-market fit for digital money. If people would want to trade digital money as a valuable asset, the governments and authorities would have to adapt accordingly(China), making the potential regulatory hurdles irrelevant.
Sometimes, Ventrue Capitalists invent rules for investments they are looking to make. Some examples include things like; “we only invest in deals within 15 miles from our offices”, “we only invest in technical founders,” “we don’t invest without pro-rata rights,” and also, “we don’t take board seats at seed.” The last one is a mistake Keith Rabois had lost many night-sleeps on, after passing on investing in Robinhood at the seed stage. The reason being, the founders, wanted him to be a board member. In retrospect, it’s clear he should’ve taken that board seat, and though he had a viable reason to reject the idea; At seed-stage, most VC firms do not have the bandwidth to be on every board of their portfolio company. That being said(not that I have the right to judge), if the startup was imposing, and his gut feeling felt right, he could’ve had probably said yes and negotiate some exit strategy or limit his participation in those board meetings.
Looking forward, I try to remember the lesson from that story, which connects well with what Scott Adams wrote in one of his books: “The better deal has its own schedule.”
I believe making hard rules when investing in the hybrid environment of startups isn’t a good idea. Learning from the mistakes of Keith, it’s essential to develop strong recognition skills, flexibility, and understand that some deals may require you to get out of your way. In some cases, it will turn out to work well.
Naval recently shared great insight on investing in his podcast; ‘You can give every deal one fatal flaw.‘
This is an excellent lesson for investors who think every deal should look perfect from the beginning.
Uber didn’t look attractive in the beginning. Just when they started, Jason Calacanis(a Sequoia Capital scout, then) gathered over 20 investors in an event to hear the pitch of Uber from the founders. 90% of them said no to them at seed-stage.
Those who ended up investing at seed did pretty well:
That teaches the classic concept of finding value in Venture Capital: being non-consensus and right. This concept is now coined by many VCs, praising themselves for “having conviction.” The reality is that when everyone thinks they have conviction, no one has it. You should WANT TO find those weird deals investors are rejecting because something seems off. It can be the founder’s background, the TAM, the timing, location, and many more things. That said, investing in every odd deal isn’t a good strategy.
The truth is that a deal can work out incredibly well, despite looking odd in the beginning. Examples can include companies like PayPal, Airbnb, Uber, Twitch, Snapchat, and many more.
Some closing thoughts
Venture capital investing may look like an easy job from the outside but is brutally hard from the inside. Managing biases is arguably the most critical job of a venture-capitalist. Finding what’s right before everyone else will remain the differentiator in generating alpha. Learning from one’s and also others’ mistakes is vital to succeeding in the VC environment, and can only be achieved with real open-mindedness.