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August 14, 2020

Common Mistakes in Early-Stage Investing – Part 3

 

Note: this is the third of four articles on best practices in early-stage investing.

Links to the rest of the series: Part I, Part II, and Part IV.

 

We’re back for the third part of our series on the fascinating world of startup investing. The series is meant as a guide to help investors avoid the common mistakes that new investors to the early-stage game often make.

Readers are encouraged to start by reading Part I and Part II — which cover Conceptual Approaches and Deal Flow Sourcing, respectively.


Introduction

For most investors, the actual Execution of Deals is the most exciting part of the investment process. Nothing else delivers quite the same thrill as pulling the trigger on a deal — and knowing that you’re now a part-owner of that startup. (The only aspect of investing that delivers a comparable feel-good rush to putting money into a company is when you finally have the satisfaction of watching that company reach a profitable exit.) 

It’s also crucial that investors treat the task of selecting deals with utmost seriousness. As Paul Graham — the founder of renowned accelerator Y Combinator — states in his seminal article on angel investing: picking the right startups to invest in is so much more important than any other aspect of the game that he worries he’s misleading his readers by even mentioning anything else. 

Now, investors should not expect (or even attempt) to pick nothing but big winners. Even VCs who do this for a living pick correctly only about one in four times. Individuals making small personal investments in startups should be careful not to expect too much all at once. The goal is not to avoid making any picks that ultimately lose money. That’s statistically almost impossible. Instead, the objective is to pick deals in a way that maximizes your chances of hitting at least one or two truly enormous winners. 


Mistake 1 – Obsessing over Buzzy Deals

There can be comfort in crowds. For some investors, the path of least resistance is simply to chase the deals that everyone else is chasing. 

In fact, there’s even a school of thought that advances following the herd as a way to pick wisely. It’s thought to harness the so-called “wisdom of the crowd.” 

However, early-stage investors should be careful not to go overboard with chasing popular deals. Even VCs and other professional investors are routinely guilty of perpetrating lemming-like behavior. They chase sectoral or technological trends that are hot today. Lemming investors then engage in VC pile-ons into the most buzzy deals within that hot area. 

Although this herd behavior sometimes works out well, it also leads to embarrassing failures. For instance, there’s the Theranos debacle (a fraudulent company that duped VCs into throwing away over $700M) and the WeWork collapse (a company that raised $13B before it imploded due to the malfeasance of its founder). 

Learn from these moments. It’s fine to develop networks and relationships with other investors. But don’t defer to herd signals so much that you’re substituting it for your own independent thinking. Instead, set aside information about what other investors may or may not be participating in a deal — and then assess the opportunity from first principles. 

The stampeding herd has historically missed countless incredible investment opportunities — deals such as Alibaba, Google, Robinhood, and Salesforce. Each of those companies are now worth billions, despite having each been rejected by dozens of VCs. The gems are out there, waiting to be discovered by investors who use their own critical thinking and independent judgment to uncover opportunities that others have overlooked.


Mistake 2 – Insisting on Negotiating Terms

The appeal of early-stage investing is the prospect of acquiring startup equity at attractively low valuations. So, one might conclude that early-stage deals would be even MORE favorable if you could negotiate down the valuations at which you invest — right?

Actually, no. Most decently positioned seed-stage companies will set the terms of their own raise. This means that they choose the format of investment — occasionally a priced round, but more commonly a SAFE or convertible note — as well as the pre-money valuation or cap, and any other key terms as needed. Because all of these terms are usually set by founders for seed-stage opportunities, there’s no negotiating. The investment opportunity is a take-it-or-leave-it deal. In fact, even in later rounds like a Series A, the only investor that can reasonably expect to negotiate terms is the round’s lead investor. All others (including major VCs) are expected to fall in line with whatever terms the lead firm has set. 

If anything, attempts by a smaller-scale investor to negotiate the terms of a seed-round will likely only harm that investor’s reputation. That makes it a dire mistake, since it’s often reputation that gets an investor invited into the most desirable deals! The early-stage investing game isn’t won or lost by negotiating terms. It’s won by ensuring that you get into at least a few deals that end up such massive winners that the exact valuation of your seed-stage investment ceases to matter. As Google CEO Eric Schmidt once advised Sheryl Sandberg (who went on to become COO of Facebook), “If you’re offered a seat on a rocket ship, don’t ask what seat. Just get on.


Mistake 3 – Being Impressed by Trivial Indicators

The world of venture investing has historically been opaque. Twenty years ago, VCs and angels wouldn’t do any PR about their investing capacities — or even make much effort to court desirable startups. Why chase founders, when you can just sit back and make them chase you instead? In that environment, most aspiring entrepreneurs didn’t even know who the top VCs were — much less how to get in touch with them or pitch them effectively.

However, this uneven power dynamic couldn’t last. Over time, there has been a reduced reliance on VC as the cost of launching companies plummeted. The spread of information through podcasts, blogs and web articles has levelled the playing field for entrepreneurs. And the rise of accelerators, crowdfunding, and other alternative funding structures has led to the so-called “democratization of venture.” In today’s capital markets, talented entrepreneurs have the upper hand. It’s the VCs and angels who must offer transparent value, if they want to ensure their participation in the most desirable deals.

This relatively recent empowerment of founders has had an unfortunate side effect. Due to the large shared pool of knowledge, many founder pitches are starting to look worryingly repetitive. This problem goes beyond just startups’ overuse of a certain overworn design aesthetic. It extends even to the content of their pitches. 

Two of the worst-offending elements in startup pitches are the “Market” and “Traction” slides. It’s de rigueur for startups to include a Total Addressable Market (TAM) analysis in every pitch. These TAM slides are commonly identifiable by their nested circles depicting Total, Addressable, and Obtainable market sizes. Meanwhile, Traction slides are expected to show something — anything! — that’s trending “up and to the right.”

Ironically, these Market and Traction slides became fixtures of startup pitch decks precisely because founders finally had more information about what VCs wanted to see. Yet these pitch elements have become so uselessly pervasive that some VCs and angels have started to disparage them, decry them, or flat-out detest them. It’s trivially easy to state that one’s hypothetical market size is in the billions. Or to pick some arbitrary traction metric such as visits or downloads and showcase it as having displayed somewhat steep growth over a handful of months. 

Investors should follow the lead of savvy VCs. Resist being persuaded by the presence of supposedly impressive TAM or Traction figures. These pitch elements are so widely offered as evidence of strong growth prospects that they can’t possibly be effective discriminators between promising opportunities and lackluster deals. 

The list of indicators that should be heeded when assessing a deal is practically boundless. It could easily be the subject of an entire doctoral dissertation. But at a minimum, a list of key assessment considerations probably ought to include such factors as:

  • A team’s unique capabilities;
  • The company’s business model and the likelihood of that business model thriving in its given market;
  • The presence of established (as well as emerging) competitors;
  • And any pathways the team might have to generate business moats and competitive defensibility.

The point is that early-stage investors should not be impressed by pitch elements that practically every startup can easily manifest. In today’s venture environment, vastness of TAM and steepness of early traction both fall into this category of trivial and unhelpful indicators.


Mistake 4 – Waiting Too Long to Commit

It’s accepted wisdom in just about any field of investing, finance, or business that “time kills all deals.”

This certainly applies to the world of early-stage investing. Good deals fill up fast! Whether it’s angels and other small-scale investors making quick decisions to back a seed-stage deal or VCs short-circuiting their own processes, the result is the same. Just like in any other market, great deals in the early-stage game don’t remain available very long.

One forgiving aspect of early-stage investing is that startups whose rounds end up oversubscribed are frequently willing to accept the surplus capital raised. However, once a founding team shuts down a round entirely, undecided investors will have missed their chance to invest. Those inactive investors will have to wait to see whether the startup makes its future rounds available to them if they want a second chance. 

This implies that early-stage investors should be prepared to make decisions with a measure of speed. This doesn’t mean abandoning your own due diligence on a deal. By all means, conduct whatever research or analysis you need to get to a level of conviction on a given opportunity. But once that step is complete, if you feel bullish about a deal don’t wait just for the sake of doing additional “reflection.” Investing in startups is about striking the right balance between deep analysis of a company’s prospects and the decisiveness to get into promising deals while you can. 

If you’ve done your homework and you genuinely feel that a company could someday capture dominant market share within its chosen industry, cast timidity aside and commit to the deal!


Conclusion

We’ve now covered typical mistakes that investors might make across three key dimensions of the early-stage game: 

  • Conceptual Approaches to investing. 
  • Deal Flow Sourcing to ensure a stream of qualified opportunities.
  • The moment of truth when Execution of Deals finally occurs, and investors must decide which opportunities are truly worthy of their capital.

With these first three dimensions overcome, investors will be underway in their journeys — assembling a steadily increasing collection of positions in startup companies. The remaining challenge is to adopt the best practices of seasoned investors by learning how to conduct savvy Portfolio Management.

 

Note: this is the third of four articles on best practices in early-stage investing.

Links to the rest of the series: Part I, Part II, and Part IV. 


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About: Rob Ness

Rob Ness is the General Partner of seed-stage VC firm Asymmetry Ventures. He also runs one of the largest syndicates on AngelList, managing a community of over 1300 angel investors. Over the past decade, Rob has invested in more than 150 early-stage deals. He graduated from UC Berkeley with a triple major in mathematics, economics and interdisciplinary studies - and completed an MPA at Harvard University.

View Rob Ness's articles

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