Be Careful of the New VC Firms Who Have No Conviction. There’s a Lot of Them.
VC’s don’t know if they’re good for 7+ years.
As a VC, you’re not “good” until your investments have both appreciated in value and your gains have been realized (meaning your investments have liquidated and you’ve received cash profits you can distribute to your LP base).
But for first time fund managers, they need to find KPI’s that track their progress (just like any new startup would). They can’t wait 7 years to “know” because they need to raise a fund at least every 3 years (the common investment period is ~3 years).
One of the KPI’s new investors track is “unrealized gains.” These are paper returns, or essentially the increase in portfolio value without having received cash to prove it.
Since “on paper” returns are often hard to judge, a good way to validate those “mark ups” are accurate is to see if a top tier VC firm is the one to have ascribed that new increase in value by investing in the company.
And so for these new VC firms another key KPI is how often they are co-investing with top tier VC firms.
It proves that they have access, that the value of their portfolio companies are relatively accurate and that the investment was probably a good one (if it goes to zero, the new VC could say “well at least First Round thought it was a good investment too!”).
This creates two major issues. The first is that there are very few new VC firms that lead rounds with strong conviction. Most write $50-$250k checks in rounds being led by other top VC firms. The goal is that eventually they’ll build enough of a track record that their LP base will be sturdy and will trust them to have their own opinion.
Some new VC firms that avoided this trap include (from my perspective): Bowery Capital, Arena Ventures, Brooklyn Bridge Ventures, Notation, Bloomberg Beta, HomeBrew, and of course a number of others. But I’d argue these are the exception, and not the rule.
And the only way to earn outlier returns is to have a correct, but different opinion than most others. This whole “tagging on to what the famous VC’s are doing” business is a bit exhausting to watch, and is one big regression to the mean. At best it leads to average returns and at worst it creates negative selection bias in that those new firms are only participating in the rounds that took the longest to close.
The second core issue is that new entrepreneurs who are working with new VC’s might find themselves in a position where their existing investors want them to raise capital from the most well known VC, not the most well suited.
The reason is that new VC is trying to build his or her brand, and by getting portfolio companies in the hands of well established firms it lowers capital markets risk and creates brand affiliation.
Often, that well known VC is the best one to lead an entrepreneur’s round, but not always (they may not have domain expertise, spend as much time mentoring a founder, etc.)
And it’s temping to fall into this trap! When we see we’ve passed on a company that General Catalyst, or High Line VP, or First Round backs we are pissed. And then we remember that if we don’t trust ourselves to disagree with those firms from time to time, if not often, we’ll never win.