A lot of LP’s (And VC firms) talk about the importance of “differentiation.”
Differentiation is what gives firms their “competitive advantage” and allows one VC firm to either attract better startups than other firms can, or pick which companies to invest in with a more informed view (they have the “magic” touch).
If someone were to go out and raise another $50M seed fund to write $500k-$1M checks in startups, people would ask: “what makes that different than all of the other seed funds out there?”
One of the ways VC funds have tried to differentiate themselves is by being vertically specialized. They might be a “fin-tech fund”, or a “real estate fund”, or a “SaaS fund.”
Does specialization work?
Sometimes yes, sometimes no. Ribbit has knocked it out of the park, and 5th Wall seems to be doing pretty well too.
But some of the best firms in the world are generalists: Sequoia, First Round, and Benchmark, for example.
One of the advantages of being a generalist is that you can be opportunistic, which by definition is important in venture capital. No one would have guessed ride sharing, or the blockchain, or social applications would have been massive creators of wealth until they were. And a fund with a thesis that precluded them from backing those companies would have missed out.
And one of the negatives of being specialized is that you have two compounding risks: The team you backed isn’t good — and the thesis they have isn’t right. Whereas with a generalist firm, in some ways, you only have the first risk (There are a ton of nuances and good counterarguments there…)
So When Does Specialization Work?
Vertical specialization works best, the earlier you go. Why?
Specialization has two great advantages:
(1) It allows you to invest in a company before there is data that validates the company is on to something.
(2) It allows you to build a network in a specific industry that is helpful with recruiting talent and customers.
(1) Underwriting w/o Data:
When I see a deal in a space I know well… like in lending — I don’t have to wait for the company to have customer data before making an equity investment. I have seen so many companies in the space that I know what default rates will probably look like, costs of origination, servicing, collections, and whether or not borrowers will take the money. I know if the company will be able to access debt capital markets… blah blah blah.
I can make the investment, at a very low valuation, before others can because I have historical data I’ve seen in the past that I can reference and inform myself with in making the next investment.
But when I see a consumer application (or something outside my expertise), I don’t have that same luxury/I don’t know if people will download the app or not… until they actually do. I just don’t know enough about social media behavior, or consumer behavior, to be able to invest in a company before they have de-risked “does anybody want this?” It’s just not what I do. So I have to invest, only once the company has been able to produce data points that validate a hypothesis I could not do with my own first-party/proprietary/historical data from other deals.
(2) Access to customers:
Most lending companies would have difficulty getting in the door with hedge funds to pitch them on their debt offering — or at least would have trouble getting taken seriously. But because we have backed a lot of lending deals, those funds will take most referrals we send them (this is the same with how seed funds help their companies reach series A firms, too).
And so when we back a brand new company — for the first — time they can get into doors they wouldn’t otherwise be able to get into. That means companies in the space are more likely to work with us, and they are more likely to be successful because we can help.
That being said, the further along a company is — the less they need someone to open the doors for them (series A companies are large enough where Fortress, and Soros, and Victory Park etc. will take the meeting).
So What is the Takeaway?
Vertical specialization is more important early on in a company’s life, than it is at the Series A and growth stages. Because at those stages companies have data (so you don’t need to rely on historical reference points to debunk hypotheses) and they can find a way to get to customers because they are no longer a tiny, irrelevant business.
And since vertical specialization does have some negatives (unable to be opportunistic, and compounding team + thesis risk), the later stage the firm, the more likely being vertically specialized is hurtful rather than helpful.
Often, firms “specialize” more because it’s a better marketing story for their fund, and than because they think it’ll make them be better investors. It becomes a crutch, rather than a lift. So it’s important to understand if it was the right thing to do, and what the real intention was.