The Differentiated VC
Note: This article was previously published on Linkedin on July 5, 2023.
VCs are such f****** hypocrites. Myself excluded. Maybe.
Perhaps I should explain.
I have often said that it is absurd how we insist that our portfolio companies be visibly and obviously a quantum level better than their competition and yet most venture funds' value propositions are virtually identical:
"We are very smart and highly connected people who can make extremely valuable introductions and offer you critical guidance at key points in your startup's journey" (usually followed quickly by) "and as former founders ourselves, we truly get what you are going through." – Every VC ever born
Honestly, other than the logo and color scheme, most VC websites are basically the same.
But buried deep in the piles of same-same-but-different funds, there are some truly differentiated strategies that a VC can take. To be clear, I am not talking about competitive advantage. A fund can be just a little bit better and win a hot deal. I am talking about approaches that are so clearly different from all but a few other funds that startups (and LPs) lean back and say, "Now that's different." That is what I want from my portfolio companies and I do not think it is fair to expect any less from myself.
With that in mind, let’s start with the more traditional untraditional VC strategies:
Be the Top Fund (in your Sector)
"Hey, we are Andreessen Horowitz / Kleiner Perkins / Sequoia / etc so we get the best deal flow. Having us on your cap table is a strong signal to other investors, customers, and partners."
Say what you want about this fund or that being overrated, if a founder thinks it is the best, there is a very good chance that he or she will go with that fund even if they don’t offer the best terms. Great strategy albeit not one that a new fund can readily take advantage of.
A variant on this strategy is to be the best in your sector. A battle of term sheets between the best generalist fund and the best specialist fund could go either way. Plus, if your sector is new enough, the ‘best’ slot may still be up for grabs.
How do you know if you are the best? Ask the startups you want to invest in. If you aren't consistently coming up in the top 3, it ain't you.
The CVC (or PE fund sidecar)
"Hey, we can be an investor and bring you both critical revenue and be a great referenceable client with which to get more customers and investment."
Also a great option but only available to large corporates... who typically fail to execute it properly. That said, get this right and you should be able to get into virtually any deal you want.
An interesting variant on this is when a private equity fund sets up an ancillary venture fund to invest in the tech used by the companies owned by the main fund (e.g., a REIT with $1B in office properties carves out a sidecar to invest in proptech). As with CVCs, startups get access to a large and varied pool of customers but the air gap between the VC fund and the end customer is even wider.
How to make this strategy work is very, very tricky. If you’d like a taste of the complexity involved, here is a series of articles I wrote on the topic.
The Fund with Strategic LPs
"Hey, all 20 of my LPs are large multi-family developers or operators who are looking for pilots."
This strategy is the logical progression from the CVC approach. The value proposition is similar, often with even more potential customers, but the weakness is even more pronounced. If the LPs cannot operationalize piloting with startups on their own, it's even harder to do it with a separate VC fund that is an arm's length away. On the other hand, when a corporate makes a large external investment, sometimes they are perversely more responsive to the VC than they would be to an internal team. Either way, this strategy takes thought and process to make it work. Getting the investment from the LPs is just the beginning.
Now let’s get into some of the less common and IMHO more interesting strategies.
Accelerator (or Venture Studio) Led
"Hey, we will roll up our sleeves and work with you from the beginning."
Been there, done that for six years. For a top accelerator, it (arguably) works but for the rest, there is a lot of adverse selection as more experienced founders opt out. And it is a massively heavy lift. Definitely differentiated but more work, risk, and time to exit. Happy to discuss the circumstances when an accelerator makes sense offline but since anyone reading this article is likely familiar with accelerators, I include it mostly for completeness.
CTO Led
“Hey, we all have extremely deep technical expertise and will save you a lot of time and make sure you get startup-killing tech decisions right."
Now things are getting interesting. Even startups with strong dev teams often lack specialized skills and rarely have the depth of experience that a ‘been there, done that, several times’ veteran CTO brings to the table so I see the appeal here. I do not have the tech chops to know how well this works across industries so it might need to be (or might work best when) paired with sector focus.
Business Development Led
“Hey, we have a dedicated business development team who will bring customers in the door and help shape up your sales team."
This one interests me a lot. After all, what startup does not want more revenue? Many funds claim to make customer introductions but having a dedicated team takes it to a different level. I have seen it first hand; Customer Sprints were one of the most attractive elements of the Dreamit v2.0 platform that I helped build.
But bizdev is too time consuming for a fund’s partners to do ‘on the side’ and staffing even a smallish, sector-focused team is too expensive for smaller funds who invest in startups who can most benefit from this differentiator.
Side note: I am exploring a structure that might make this viable for small, seed stage funds. If you are interested in learning more, send me an email.
Recruiting Led
"Hey, we have a dedicated team of recruiters who will help you fill key roles."
This one also interests me a lot for many of the same reasons as the prior example… with most of the same caveats.
One possible difference: a startup’s staffing needs grow exponentially as they scale and a mid or later stage fund could be large enough to support a dedicated team. But at that stage a startup can find recruiters on its own so how valuable would this actually be? I am not sure….
Design (or Development) Led
"Hey, we are an award winning design firm and can help you create beautiful sites and apps with the best user experience."
I see this approach from time to time and it is always a design firm that decides to reduce its fees in exchange for equity, never a true fund. The problem is they are not qualified to assess a startup for investment so the equity basically becomes a lottery ticket and their program devolves into a way to cut prices when times are slow without actually admitting it. The proof? They never turn down full price paying customers to free up staff to work on a startup.
Another variant is the dev shop that builds sites and apps for non-technical founders for equity. In addition to the problem above, tech is often a critical component and VCs will simply not invest in a startup that outsources development. More subtly, having limited but in-house tech leads to focusing on which features deliver the most bang for the time to build; outsourced dev means asking “is this feature worth the cost.” The former makes a startup move fast, the latter is a recipe for delay.
Now let’s get into the even rarer, structurally differentiated VC strategies
The Un-fund
"Hey, we are not structured like a typical VC fund so we don't have a 10-year expiration date that will put pressures on us that have nothing to do with your business."
This approach includes both evergreen funds that recycle the proceeds of the exits into new investments as well as family offices and corporations investing balance sheet capital. Both these investors often tout their ability to be a more patient source of capital. Traditional VC funds definitely have an expiration date; they rarely invest after year 6 or 7 and by years 9 and 10 start to get pretty antsy about getting out of their remaining investments so they can close the fund. That said, they often have raised later funds that can continue to invest in growing portfolio companies and even (with a bit of care to avoid conflicts of interest) have those later funds buy out their earlier fund’s stake.
On the flip side, these types of funds are subject to their own pressures, Economic headwinds, slower than expected exits, corporate or family politics etc. can make it hard to access the promised funds and it is times like those when these investors wish they had dedicated capital like a traditional VC fund.
So IMHO this structure isn't inherently more or less risky than traditional VC, just different. But is it differentiated enough that some startups - and more importantly, some of the best startups - prefer this kind of investor to a traditional VC? Honestly, I don't know.
The Pro Rata Specialist
There's no "hey startup" in this strategy. Funds like this don't make the initial investment in startups. Instead, they partner with other funds and accelerators to buy up unused pro rata. They can then choose to invest in the companies that are succeeding and that they would otherwise have to fight hard, and often unsuccessfully, to get into. Think of it as a backdoor into great startups. It is not an easy strategy and there is definitely the risk of adverse selection as the funds who made the initial investment are less likely to sell the pro rata in their very best funds. Also, there may not be room for many funds to take that approach. A few funds have been doing it for years. You just don’t hear about them often because they tend to fly under the radar.
A related strategy is the secondaries fund. As a traditional VC fund approaches the end of its term, it typically has a few investments that are doing just OK. They are typically profitable but too small to sell or the founders still own enough equity that the fund cannot force them to sell. Since these startups are likely to be small exits and have already been in their portfolio for a decade, the ROI on them is low. So as far as the VC is concerned, they are basically a loss. But the startups have some value and for another fund that can buy out the original VC’s stake for pennies on the dollar, those startups can be fairly cheap lottery tickets. Most startups will never hear of these secondary funds but experienced VCs know them well.
There are not a lot of things in venture that are 100% but here’s one of them: I am 100% sure that I have missed some interesting, differentiated strategies so if you know of one, please drop me a line.