by Noah Jessop
As an entrepreneur, I pitched and got the chance to work with a number of great firms. But when I came to the venture side, there was a whole new element Iâd never really considered before, quietly shaping the entire ecosystem: an investorâs deal flow.
Now, as I talk to other investors, the concerns around deal flow was pretty straightforward:
How do I get more good deal flow? More is better. Where can I cultivate to get future good deal flow?
And thatâs generally where the conversation stops.
Thereâs a term for the constantly changing source of new customers in operating companies: media mix.
As an operator, how can I expect to run my business the same when the leads or potential new customers are coming from different sources? We expect additional competition on an important keyword to change an operating companyâs ROI. But when applied to venture capital, the media mix question quickly gets lost. Unlike an operating company, who must convince each and every customer to pay their price, in some percentage of instances, investors actually control the conversion event. (i.e. if they offer money on good terms, it will be accepted.)
So looking at conversion rate hardly scratches the surface. What follows are the questions that are still unanswered for me.
Question #1: Is great deal flow a venture firmâs edge?
To start to consider this question, Iâve found it easier to use Charlie Mungerâs mental model of inversion:
What would you do to have an edge as a new fund?
Iâll argue itâs simple (and not entirely intuitive): look more closely at the investments you can access.
Sometimes new startups complete their financing very quicklyâââeither with firms theyâve known for a long time or by running a tight, competitive process. But more often than not, they meet a few reputable folks via their angels and advisors, maybe even before theyâve started to really tell their story the best they can. (Or maybe even before theyâve decided to raise.)
These earliest pitchesâââwhere itâs not clear whether the company is raisingâââoften get missed by firms with a lot of high-quality deal flow. Iâve written at length before about how rounds need to get packaged to move swiftly. No matter how high quality the team, how good the market, these early pitches can just get lost in the noise. Not necessarily better investmentsâââbut teams that already have a term sheet, have unlocked a major traction milestone, or simply are just a few years further along as a business.
Most rounds take a number of weeks or months awhile to coalesceâââas teams hit new milestones and get better at telling their story:
Time on X-axis, Traction & Quality of teamâs pitch on Y-axis
In any given deal, when do new firms have an edge? Before itâs clearly a winning company (at least at this stage) to other potential investors.
How do they capitalize on this edge? New fund managers, their industry specialties and existing relationships aside, simply have more time to develop conviction for a deal. They have fewer new meetings to take and less of a track record that will allow them to win deals that they come into late.
So when they see a business that they understand (or they meet founders they particularly like), they have more time to de-risk the parts of the story that arenât yet entirely clear. Put another way: some of the overlooked outliers will turn into incredible investments. But more deal flow lets investors put these opportunities in the âtoo hardâ pile and focus their time on other safer bets.
Question #2: Is seeing deals early really better?
Only seeing deals when itâs too late isnât helpful for most investors. But consider a common case for the best firms:
- Meet a promising team at the beginning of their raise (first 5 meetings)
- Reconnect with this team a few months later when the team has a term sheet or two already
Deals often end up moving too slow and then too fast. Itâs hard for a VC to start looking at a deal when things itâs already moving very quickly. Itâs often very difficult for a new investor considering leading a round, no matter how much they like the business and founders, to do the requisite work to reach conviction for an investment in this compressed timeline.
For founders to consider a new suitor late in the process, when there is still uncertainty about whether they are willing and able to invest, that firm must be in such high regard to slow the founders from accepting an existing âbird-in-handâ term sheet.
Most VCs say that they want to meet companies early and get to establish a few data points along the companyâs progression. This progression is helpful only if the company doesnât accelerate beyond the stage of checks that given firm is able to write.
Few will say it, but sometimes, itâs just less work to meet a company when it about to start a proper fundraising processâââmoving fast enough to know the deal will happen, but slow enough to get to do the diligence that firm wants to do. A lack of diligence or a relationship will be soon be justified to a partnership by saying, âit became a very competitive process and we wanted to win this opportunity.â
As a founder, I always called the coalescing of a round âcreating a discrete moment of FOMOââââmy advice now would be to indicate when things are starting to move earlyâŚbut only when thereâs good certainty of the deal progressing.
Question #3: Is âgoodâ deal flow seeing all the âhotâ deals?
Venture capital is a business of exceptions and outliers. More often than not, it may take a few years before we have any understanding of which investments actually stand to be âgoodââââand even then, actual investment success in any given company canât be counted on until meaningful liquidity is realized.
So we look for shortcuts. We look for proxies that weâââas investorsâââare doing well. That we are seeing the companies that will matter in 5â10 years.
Unfortunately, the âhotâ deal is a readily available, and overused, shortcut. Competition at the fundraising stage is a cheap proxy for eventual success. Often, when everyone wants to do a deal, it might be because itâs consensus sounds right but isnât.
Worse, investors early in the cycle of building their portfolios may be led astray from the eventual returns by chasing hot deals. The short-term incentives these VCs face make it important to do something hot and consensus, with the hope that it will have appreciated by the time they need to raise more capital for their next fund.
Similar challenges exist at older, more established (and possibly more political) firmsâââsometimes âhotâ deals are easier to get through the partnership. Winning a deal from other suitors may be justification enough to invest.
This whole process creates a Keynesian beauty contest of startupsâââinvestors speculating which companies will look most appealing to future investorâs belief of what other investors after them may like. (In the original, Keynes proposed a contest where the âcorrectâ answer was to guess which faces the rest of the crowd might vote most popular.)
This exercise, by definition, is something else in disguise: reversion to the mean.
Hardly helpful for investors seeking outlier performance on the logarithmic-style outcome result field of venture-style exceptions. One method to break this model is simple: investors might pay the very highest prices for the deals that likely are truly outliers AND already widely discovered.
Question #4: Does a firmâs deal flow continue to improve over time?
Ironically, investors spend a lot of time thinking about a prospective investment will acquire new customers and growâââlooking at how the companyâs user acquisition costs and channels will change as the business scales.
But as we mentioned earlier, an investorâs own âmedia mixâ is changingâââand they control the conversion event, so hard to track really whatâs happening.
Add this to VCâs slow feedback cycle: investors really donât know the outcomes of their previous deals. Going forward, structurally they can only invest in deals that are part of their deal flow.
All of which is to say: an investorâs strategy is tightly coupled (and easily changed) by the deals that they see.
Getting lots of referral deal flow takes up timeâââand can fill all the time and space for potential opportunities. For example, how many high-deal-flow venture firms chose to invest in the Ethereum ICO? (Which today, presuming you didnât sell at all along the way, would be an 1,800X return.) Good deal flow may be helpful, but it may look âstartup-yâ (or now âcrypto-yâ) and nothing like how tomorrowâs outliers will start.
In addition to having less time to evaluate new opportunities and greenfield areas, more deal flow has a hidden side: investors will progressively see more companies at the later stage of traction for their stage. Why? In choosing which companies to spend time with, commercial traction is an easy (and relevant) shortcut. Why look at the business doing $50K monthly revenue when you can look at one at the same financing stage doing $200K?
One might argue that firms raising progressively larger funds and moving later stages isnât just about collecting more feesâââitâs just about capitalizing on the deal flow that they have naturally built over time.
Question #5: Do the âgreatâ deals come from great referral sources?
I witness many investors seeking to invest in âhigh qualityâ lead sources. While certainly thereâs positive signal from where founders previously worked, or who previously invested, itâs helpful but not sufficient. Else, top investors could simply back every Google and Facebook alum and make it so.
If investors establish all the âgoodâ lead sources and see many of the people coming out of the top few companiesâââhow can they think they will have differentiated flow? We established above, seeing things the very earliest, in most cases, isnât necessarily an advantage for winning that deal.
The âgreatâ source of the next outlier deal is truly unknowable by definition.
The best an investor can strive for is to build their reputation (and stand for something) and travel far and wideâŚ
If you read this farâââor think this post might help an entrepreneur or investor you knowâââconsider hitting âđâ below to help spread this piece. Tell me how you met your best investment to date. And continue the conversation @njess.