Behind the Randomness of Early Stage Investing
"I just don’t understand how investors think. They say something but do something else – it doesn’t make any sense. Most of them probably don’t even know what they’re doing."
This is the most common frustration I’ve heard from founders when they’re raising their first few rounds. From the outside, early-stage investing might look like a lot of random decisions. But that’s not completely true.
Every investor has a set of somewhat similar guiding principles to make pass/invest decisions. However, there’s a great deal of variety in how different investors apply them. I’ll try to articulate both – the commonalities and the differences so you can hopefully make some sense of it.
All or Nothing
The underlying truth is that early stage investing is a binary process – most investments are likely to fail, and so the ones that succeed have to be huge. For each investment, the investor is asking themselves if this company can be a fund returner. If they’re investing 2-5% of the fund on average into a company, that translates to a 20-50x return expectation. The most successful investments return the fund many times over.
This is also the #1 reason why investors decline most of the companies they speak to. Because they don’t see how it can become large enough within their holding period to give them such kinds of returns. So they’ll tell you “we don’t think it’s a venture-scale business”.
This also means that investors might choose to pass on what might look like sensible and de-risked businesses, purely because the upside isn’t large enough. Investors are fairly comfortable in making risky bets – they can put up with nearly any amount of uncertainty as long as they believe that the potential reward can be large enough.
I’ve told lots of founder friends that investing is fundamentally a process of saying no. That’s my default starting position. Then, I’m looking for signals that force me to make exceptions. And broadly speaking, there are two sources of these exceptions.
Founders
Founders are the only source of stability in an otherwise uncertain endeavour. Investors almost treat it as a given that the product and market will evolve as startups make progress so the most important factor is the competence of founders to do that. But, how do investors figure out if founders are that good?
- The best founders are extremely clear thinkers and have a strong point of view – they could be wrong but they know exactly what they want to do and have a plan on how they intend to do it.
- In most cases, their point of view is grounded in unique, sometimes contrarian, insights about the problem, the market, and/or the user. It’s not a theoretical perspective which also allows them to be adaptable to how the market responds.
- They create certainty out of ambiguity – one by one, they solve the hardest, riskiest aspects of the business and exercise judgement on what needs to be solved now v/s later. They are not trying to solve all problems at once.
You might wonder how can an investor evaluate such deep behavioural traits through just a few meetings? That’s why it’s easy for investors to invest in founders they already know. But truth be told, these traits are so rare that they are hard to miss. Every investor has a benchmark of what they consider to be great founders that’s based on the people that they’ve invested in so they’re always evaluating you against them.
Another common reason why investors decline even when the business might potentially be interesting is when they can’t build conviction in the founding team – sometimes, that’s because in their judgement, there’s a mismatch between the founders’ skillsets and the market requirements.
Markets
Markets are an under-rated and under-explained factor in investment decisions. Every investor will say that founders are the most important but I think markets are equally important. So, what makes a market attractive?
The most important thing is timing. What is changing that creates an opportunity for disruption? There could be macro forces or micro behaviors or most importantly, technological breakthroughs – sometimes, these combine to create once-in-a-lifetime window to build a large business. TAM is probably the most debatable factor. History has shown that the most successful startups create markets through such opportunities. But, when it’s difficult to see the potential new demand (and it’s extremely difficult), investors resort to saying that the TAM isn’t large enough.
This is also why you see certain markets becoming hot and most of the capital flows to businesses in that market, and this keeps changing every 2-3 years. Startups are hard to build as is, and to build in a market with no tailwinds, that’s a very difficult investment. Apart from that, investors might also choose to decline companies that are operating in spaces they don’t understand well or don’t have a thesis on. Nearly all investors will have defined competence in certain sectors.
Finally, let’s get to how investors think and evaluate companies.
Mental Model
Investors speak to hundreds of companies every year – different sectors, founders, business models. Over the years, this runs into thousands of companies. With each conversation, they start to build their own mental models – how different markets work – what are the most important drivers, what approaches have been tried – what worked and what didn’t work, how businesses can scale and where do they run into market constraints, what monetisation models work for what kind of businesses and audiences, what kind of disruptions technology has created in the past, where can technology create the most value, so on and so forth. Now, add to that the learnings and observations from watching portfolio companies – those that fail, and those that succeed. With any investor, portfolio companies form a large part of this context.
As this knowledge compounds, they start to form their own perspectives – they develop a natural inclination towards certain kind of founders, markets and businesses, and a natural aversion towards certain kinds of founders, markets and businesses. So when they’re talking to any new founder, or evaluating any new startup, they’re sub-consciously or even consciously contextualising that pitch with what they know and believe.
It’s not an exact system but more a heuristic-based process. So whatever aligns well with them, they take forward, and whatever doesn’t, they drop. That’s confusing because as a founder, different investors might react very differently to your same pitch. The biggest risk of this system is the failure to identify innovation or contrarian approaches. By definition, the next genuinely path-breaking startup would look completely different to anything that exists. From what I’ve seen, it’s very hard for founders to change what an investor believes and you’d need either solid evidence or a leap of faith from them.
From an investor perspective, early stage investing is essentially building conviction in the very few known things that is greater than the uncertainty of everything else that’s unknown. And it’s extremely difficult to rationalise that into a science. One has to be irrational to believe in a future that’s not obvious.