When it Makes Sense to Be a Contrarian Investor — And When it Doesn’t.
I was speaking with a successful investor (who ran a large hedge fund, and who also has a ridiculous angel investing track record) at Capital Camp a couple of weeks back, and he made the following comment to me:
“In public markets, it’s good to be contrarian. But I’ve learned that in private markets it’s not. It’s better to rely on having early access into a founder, that everyone believes in so that a lot of demand comes into the company from other equity investors.”
I hated the comment for a lot of reasons (I like to be contrarian, just like everyone else in VC likes to be (or pretends they like to be)).
But I didn’t necessarily think it was wrong either.
I’ve had companies whose numbers looked identical — but one CEO was willing to spend a lot of time in the VC community — tell the story of the business, and raise capital at crazy high valuations, whereas the other stays with his customers, doesn’t speak to VC’s unless he absolutely has to — and has raised at 1/4th the price. The former company is a far more consensus bet — but I believe in them both equally.
It took me two weeks to decide which parts of the comment I thought were right, and which parts I thought were wrong.
Why Being Contrarian In Public Markets Work — and Why The Same Strategy Doesn’t Always Work in Startup Investing
In public markets — assuming you have a fund structure where your investors can’t redeem too quickly — or a reputation where they won’t redeem before you can prove out your thesis… it’s possible to invest in a security, be patient, and eventually let the market realize you’ve been right all along and watch your investment appreciate. This can often take 2–3 years.
The key word though… is “eventually.”
These public securities are likely issued by companies who, if they do badly will still raise more capital… it’ll just be more expensive as the stock price will be lower/rates higher. But at least the company will survive (usually).
The problem in startup investing is that new companies live on 12 month horizons. If you fund a company — it usually has about 1 year to make lots of progress before starting to go out to market and raise its next round within the ~18 month period that usually occurs before rounds. And these outcomes are less binary. A round either happens, or doesn’t. If it doesn’t — the company goes out of business, and down rounds/bridge rounds are not a “given.” You can’t just “issue securities at a lower price” like public companies do. VC’s hate participating in down rounds.
So unlike in public market investing — where it’s unlikely a company will go totally bankrupt within 12 months (it does happen), for startups there is no “eventually.” Things have to happen fast.
Plus, so many market dynamics are at play. In public markets there are research analysts tracking a company who — when they make progress — get noticed. But in startups, it’s up to a founder to be GOOD AT REPORTING/UPDATING THE MARKET THEMSELVES to make sure people realize something has changed within 12 months. (or it’s up to a high quality VC to make sure their network is staying informed).
That means the numbers don’t just speak for themselves. Backing founders/companies with board members who are good at marketing their equity is important.
And the founders who were good at marketing their equity — probably raised “consensus/hot” rounds from the very beginning — so were the right people to back despite the investment not being contrarian.
When Does Being a Consensus Investor Work In Private Markets? And When Does Being a Contrarian Investor Work in Private Markets?
My main takeaway is — it’s best to be a consensus investor if you exhibit the following qualities:
· You write small checks relative to the rounds you invest in — because it’s easier to participate in competed rounds
· You don’t make a ton of bets, so even if you’re investing in a round that’s too highly priced, a 10x can seriously move the needle for you
· You have access to a unique network such that you can get into rounds the average investor would not be able to get into
· You have a type of skill/network where people allow you to participate in round that is oversubscribed, where your advantage is buying equity at a lower price than the consensus in exchange for your sweat-equity/expected support
· You don’t have the ability to continue to fund the company if it takes longer than expected to prove the market wrong
It is better to be a contrarian investor if:
· Your check size is large relative to the size of rounds you invest in — to the point where you have to lead deals — the only way to get into rounds this way is by seeing something others didn’t, having a view that an idea is good when others don’t believe it’s good, or having a reputation such that founders would want to take your capital at a lower price than they’d accept other people’s capital
· You make enough investments where you are okay with a large dispersion of returns, and are okay with some 0’s so long as you hit some home runs
· You have a less well-known brand such that “winning hot deals on brand” is harder — and you rely on being contrarian more
· You have such a crazy brand (like USV or Sequoia) that the fact that you backed a deal makes it consensus
· You have a fund structure such that you can invest enough initially to be certain you’ve given a company enough time to reach an inflection point that could drive new consensus — or a fund that allows you to lead two rounds in a row to help give the founder more runway to prove numbers than normal
If you don’t have a fund that can give a founder patience as they reach milestones — you have to really ask yourself: “am I investing in a contrarian investment, that I’m certain can become less contrarian in future rounds based on the milestones they’ll be achieving with my initial dollars?” ß that is a really hard question to be certain of.