In the new normal for VC, builders will win

Though this may be a tough pill for some investors, we are never going back to the days where venture capital firms can win by being the only term sheet on the table — the industry has raised too much capital for that to be possible, even for the most exceptional startups.

As VCs continue to financialize themselves as the hedge fund and private equity industries did in decades past, VC firms must win with information advantage or by building the power and founder relationship to beat competitors head-on.

Offering startups more money at higher prices was recently a popular way to secure allocations in desirable companies, but whether such decisions were backed by rigorous and compelling data was often questionable.

Regardless, there are indeed legitimate, hard-earned info asymmetries that lead to unique deal access: exceptionally intimate founder relationships, superior sourcing processes, the capability to synthesize clear-eyed theses and so on.

There are also ways to win in purely competitive scenarios where VCs have material information that their peers don’t, but I wouldn’t bet on the vast majority of firms getting much more than the marginal allocation left over by a16z, Sequoia and other large, sophisticated firms.

In any case, it seems clear that the winners in venture over the next decade will be full-stack firms that continue to financialize the industry and boutique firms that successfully leverage specific networks or knowledge bases. Looking deep to the vision and initiative of each founder is the only way forward.

So, how are firms evolving with this in mind?

Collecting deal flow: It takes a village

Sequoia innovated with their scout program years ago. In hindsight, it feels obvious that plugged-in operators tend to get the first look at founders spinning out to build a company. But at the time, this deal-flow strategy was rather unique.

These days, as most firms have either copied or considered copying the scout program structure, deal flow becomes more commoditized. We’re approaching the limit on how much firms can offer scouts in terms of carry or check sizes. There’s limited loyalty, and deal flow often finds itself quickly propagating around anyway.

The advantage is no longer in the concept of a scout program, but rather in new ways to find more deal flow than an internal team could ever source on their own.

AngelList has done a wonderful job with Rollup Vehicles (everyone can be an angel), SPVs (everyone can be a GP) and funds/subscriptions (everyone can be an LP). The data gathered by owning this infrastructure is nearly unparalleled, and enabling this functionality makes a difference to those that use it.

Firms that consistently write small LP checks in emerging managers have also done a great job of “buying” deal flow at large scale. For example, a16z systematically evaluates the investments made by angel, “micro,” and seed funds they back. What an excellent way to get a scoop on future rounds before any formal processes are run by founders!

These examples represent two extremes: Tools like AngelList “arm the masses” of the tech world, while a16z’s strategy works well for those with billions to invest.

I expect firms to be highly intentional and experimental in finding new ways to organize external sourcing networks with new incentive structures.

Network analysis: Thinking smarter, not just bigger

As venture firms of all sizes gather lists of personal contacts, event attendees, Substack subscribers, Twitter and LinkedIn connections, and more, the need to understand rather than orchestrate a VC’s network becomes clearer.

The techniques for doing this are rather powerful given how simple some of the actual analysis can be. A precocious high school student could learn how to compute various traits of a network graph. One of my favorite examples is this post about a hypothetical analysis of 1772 New England’s social networks, which shows how trivial it would be to find Paul Revere’s centrality and nip the American Revolution in the bud.

I often think back to the First Round post on Chris Fralic’s networking style. The tactics of developing a personal network have become reduced to a science. Many have since optimized these methods. But actually operationalizing that at the firm level, at a scale beyond the individual, is far from realized.

With tools to analyze networks not just build networks, VCs can supercharge sourcing and make sense of the noise in a world where everybody seems to have some role in the venture ecosystem as described above.

Here’s what that looks like, specifically:

Software tools: Eating venture, like everything else

Salesforce, Affinity, the infamous Superhuman plus Airtable deal tracking combo and other tools have emerged as core parts of the VC stack. But clearly, we have not reached the “end of history” when it comes to operating a firm.

The hedge fund and private equity worlds started out with relatively simple tools for doing diligence on companies. These days, it’s common for analysts to write code in Jupyter notebooks not just edit cells in Excel. Some firms have built out proprietary data pipelines feeding into models with a combination of homegrown and procured information streams.

Obviously, VCs pasting data from LinkedIn to Salesforce is not the future.

Crossover firms such as Coatue have already applied the hedge-fund lessons to venture capital. Coatue invested in DoorDash, for example, partly because the firm put together a sophisticated model of restaurants ranked by growth efficiency and competitive relevance. This was a game of data and computation not one of spreadsheet modeling.

Founders — especially those in the early stages of company building without the time or resources to construct their own market intelligence systems — can materially benefit from such support.

With a focus on sourcing and internal operations, some firms are quietly building software for custom-designed workflows. These come in a few forms:

• Web-scraping tools to automatically gather new startup leads. See harmonic.ai as a productized version of this.
• Deal-flow management that helps teams work together rather than individually. Consider how the network graph analysis described above might work with a custom system rather than Salesforce.
• Community tools that connect portfolio founders, scouts, friends of the firm and more. YC’s BookFace platform was years ahead of its time.

While it seems like a no-brainer addition to any firm’s ops cadence, I’m actually pessimistic about the adoption of software, for two reasons. The first reason is that VCs tend to be nontechnical. It’s rare for general and managing partners that lead the firm to have the competence to hire and manage a product org.

The second reason I’m pessimistic is that engineering, product and design teams must be paid out of management fees. As we all know, many managers pocket their 2% fee as a hefty salary. The simple reality is that many managers will not want to take a significant pay cut in the short term to better empower the firm in the long term. (I would love to see data on how returns correlate with a manager’s ratio of salary to total management fee stream. I’m sure there is an LP out there that has crunched the numbers at some point.)

Platform 2.0

While tech is becoming an increasing focus of value add for VC firms, platforms aren’t going away. The traditional platform stack (events, talent, customer development, PR) does move the needle, if not sporadically, as founders focus on different priorities over time.

Tracking the investment that firms make in their platforms is best done by tracking talent flow. Former TechCrunch Managing Editor Danny Crichton joined Lux Capital as head of Editorial. Sequoia’s VP of Data was formerly the head of Data at Rubrik, a leading enterprise software company. There are many similar examples.

This is an old trend that’s been developing for years since the start of the platform era, but there is much room to grow.

Highly focused vertical-specific efforts have also been successful (think Jason Lemkin building SaaStr’s annual conference with 10,000+ attendees focused on SaaS). Canonical events and industry platforms that have yet to be built in other spaces seem to be on the roadmap for other operators. Winning in a vertical can give an enduring edge in sourcing and winning deals.

Productization

At the root of these software and platform efforts is the need to build hard power not just brand and network expansion.

We’ve spent time productizing at Contrary. Our jobs site, Startup Search, aggregates thousands of job seekers and helps direct them to high-growth companies, including our portfolio companies. We built Contrary Research to make some of our private market analysis open to the public and useful to others. These efforts are highly scalable compared to everything else we do, so we’re doubling down in 2023.

Though not strictly a venture firm, I do appreciate that AngelList spun out Wellfound, their own hiring marketplace. NFX created Signal, a marketplace/aggregator of both early-stage startups and investors. Nobody has quite dominated the market yet, and whoever does will reap enormous rewards.

SignalFire has raised nearly $2 billion with the mission of constructing an all-in-one data-driven platform. Their Beacon Talent product lets founders target potential recruits and is paired with market intelligence capability meant to help founders make product decisions.

I will always reference Hacker News as the all-time great product in the venture world. How much would YC pay for HN if it was owned by someone else? One can credibly argue that HN is worth as much as globally recognized news outlets, say $300 million, simply because HN monetizes incredibly well through YC’s venture fund.

Any firm with AUM north of $500 million should have at least one idea or asset worth productizing. Money is no object at that point. There is much to build — we’re just getting started!

Open questions for GPs and LPs alike

As much as 2023 will be a year that pushes firms to deliberately differentiate themselves, none of the above is strictly needed to deliver stellar returns.

For LPs thinking about the decade to come, I wonder:

• Is there room for anybody in between small emerging managers and large multistage ecosystems? What happens to the generic midsize firms that can’t play for small noncompetitive allocations but also can’t win against larger, more developed firms?
• To what degree is there loyalty between founders and investors? Are all of these innovations secondary to simple factors such as brand and deal terms? If GPs build a truly close personal relationship with founders, do they need “value add” to win the deal?
• Is there an enduring edge in platform value add, or does the GP ultimately make or break the portfolio? I can think of many cases where founders have chosen investors solely on the basis of moving fast and asking the most insightful questions.

In conclusion, we have certainly not reached the “end of history” in venture. Regardless of one’s view on the questions above, it’s clear that some action must be taken to stay relevant on a long enough time horizon.