3rd Wave VC — Precision Capital

Photo by Andrea Sonda on Unsplash

Venture capital in its traditional form is an amazing product for the right companies (and a great career path for the right investors). This is proven out in the data, as the industry’s impact punches above its weight relative to how much capital is deployed in the sector. A 2015 Stanford study found that VC-backed companies were responsible for 57% of the market capitalization of all US companies founded since 1979.

Over the last decade, institutional investors and corporations deploying capital have looked to the technology sector for growth that they’ve struggled to find elsewhere and at the same time, as the common trope goes, every company new and old is now a tech company.

This expansion of interest from investors that back VC funds and the seemingly consensus perception of an increasing market into which VC dollars can be deployed has led to the record influx of capital into VC firms that anyone reading is likely aware of.

But venture capital can be a very blunt force tool and one element of the “every company is a tech company” market expansion that many LPs, VC, and founders under-indexed on for a long time was the idea that some of the technology and technology-enabled startups being built would be better served with more targeted financing arrangements more suited to the markets they operate in, the products they are building, and the goals of the founding team — especially at the early stages since the decisions made at the outset around whether to jump on the venture track or not have an outsize impact on the long term arc of a business.

The ecosystem’s need for more aligned capital options is starting to be met by a new wave of firms, investing what I will call Precision Capital.

Before jumping into Precision Capital, I’ll quickly comment on the notion of 3rd Wave referenced in the title. Essentially, I see Precision Capital as an evolution of the early stage venture model building off of the Partner-Driven model pioneered by firms like SV Angel and Floodgate and then off of the Platform model brought to life by First Round and others. I defined those two categories in a Twitter thread on the topic and believe there is a ton of innovation happening within those two segments of the market as well.

Precision Capital

The idea that early stage ventures can and should pursue other forms of financing beyond typical VC is not new.

As CoVenture’s Ali Hamed noted in his recent post about Equity Efficient companies, SaaS loans and venture debt have long been a piece of the capital stack and are becoming more and more prevalent with the growth of SaaS Capital, Lighter Capital, and Clearbanc among others.

These firms are early players in the Precision Capital segment of the market, where firms bring to bear a holistic capital stack tailored to the specific needs of companies in a certain industry or with a certain business model and intend to become a one-stop shop for most or all of a given venture’s capital needs — if not forever, then at least until the company reaches a scale where traditional late stage or public market financing options are available and applicable.

The idea is to give companies the option to get off the VC track or avoid it in the first place while still seeking high growth and global scale (have your cake and eat it too, I guess).

The long term commitment to a specific vertical or type of company in need of new capital solutions allows these firms to establish a unique data set and deep operational capabilities with companies in the space and, over time, pull more and more promising ventures away from the pure-play VC track and into their sphere.

By offering alternative financial products (non dilutive capital, revenue agreements, etc.), the model also has the potential to shift the risk/return curve for LPs looking to access growth in industries where technology is playing a bigger role but who are not interested in the power law dice roll of traditional venture capital or unable to get into top tier firms in the previous categories.

The combination of these elements is what distinguishes Precision Capital from vertical focused venture funds or “quant” oriented VC-track efforts that are actually (very interesting and needed) evolutions of Partner-Driven or Platform Capital models.

To be clear, a lot of this will still look like venture capital in the near term and not all the firms will run the exact same playbook (just like in more traditional VC).

This is because proving out a successful Precision Capital strategy will require firms to first show they possess a traditional VC skillset — sourcing, selecting and supporting great companies — that is supported by a unique structural edge. They will also need to exhibit patience and a repeatable framework to build a long-term data asset that can be used to underpin new financial products.

One exciting example of the Precision Capital model comes from Urban.us, a great firm focused on backing early stage urban technology companies. True to Precision Capital form, Urban.us started off with a small seed stage venture fund before expanding to run an accelerator with Mini, the automaker. The success of these two efforts have given Urban.us the credibility within the markets that matter to them to start branching out and playing a larger role in the non-equity pieces of the capital stack for the companies they work with.

This is done through the recently announced Perl Street, which founder Shaun Abrahamson described in a recent post as:

Exploring the growing universe of non-equity options for startups ways by providing non-dilutive funding to operate fleets of EVs and residential batteries or to find funding for co-living projects. We see a growing list of emerging city assets that could be financed without requiring founders to sell more of their companies.

Other examples include Circle Up (Ryan Caldbeck), a firm whose quantitative approach to CPG investing has already helped a large number of companies take a different approach to growth, and Indie.vc, whose equity model is less dependent on chasing large follow on rounds and generating billion dollar exits.

In addition to these firms and others like them, I believe there are interesting ways for family offices and corporations to run the Precision Capital playbook and will write more about that down the road.

Challenges of Precision Capital

As with any new innovation, Precision Capital has a ton of drawbacks and is worse in a lot of ways relative to more traditional VC funding models.

Even an investor like Bryce Roberts of the aforementioned Indie.vc, a pioneer with an outstanding track record in seed stage investing, lost 80% of his LP base when when he “stuck his neck out” to focus his investing on Indie.vc.

A few major challenges I see:

Infrastructural Inertia — Every few months, I come across a Twitter thread or article lamenting the 2 and 20 VC model…how it can create counterproductive behavior from VCs (grow AUM, collect fees), is a function of lazy thinking from LPs, etc.

What is more likely happening is a process that starts with career risk aversion and lack of incentives to change at the LP level — don’t want to rock the boat too much for one of the smaller asset classes by allocation percentage — and filters down to VCs dependent on that institutional capital deciding to focus their “differentiation” story on how they will deploy the capital instead of fighting battles to change the culture and incentive structure at the LP level.

This creates challenges up and down the capital stack for firms wanting to employ a different model and requires them to do more work both in finding the right LPs and in telling their story once they gain an audience.

Opportunity Size — I recently read two very insightful pieces of writing — one from Ezra Galston of Starting Line VC in his quarterly LP letter (h/t Dave Ambrose) and one from Fred Wilson — that use the frameworks of other top investors to make points about the importance of being able to gain conviction around market opportunities that don’t yet exist — but could and should.

Fred Wilson’s partner, Brad Burnham, calls this “finding the narrow point of the wedge”.

The analogy is trying to hammer a piece of metal into a block of wood. If the metal is large and flat, you can’t do it. But if it is narrow and thin, you can. And, of course, once you get the narrow point of the wedge into the block of wood, you can hammer it all the way in.

Some of the best companies have been built in markets that looked small initially to investors and employees that may have passed on getting involved — there were no predecessors from whom to accurately gauge the size of the opportunity and many missed these opportunities as a result.

Similar blind spots — from both LPs and potential employees needed to build out the Precision Capital — will prove challenging for some early firms to overcome, especially if they are trying to come to market before they have fully proved out their ability to execute on a less complex VC strategy.

Today, it is unclear how many verticals, business models, or industries there are that are:

  1. Meaningfully underserved by the VC model and
  2. Present a large enough financial opportunity for this model to grow beyond just a handful of niche-focused boutique firms and attract real institutional capital.

Operational Complexity — This goes for how the firm is run and for what impact the capital will have on the ventures receiving it.

In addition to building out a team that can operate many elements of the traditional venture model at a high level — again, the idea with Precision Capital is generally that firms are still aiming to back high growth, global scale companies — these firms must attract and retain individuals capable of evaluating new types of risk and deploying capital into that. The uncertainty around what type of profile will best fit in with these firms may may make recruitment a taller task.

Firms must also consider the long term implications of the capital they are providing to ventures and ensure that they are not layering on too much complexity to companies at too early of a stage.

Data will also be crucial in capitalizing on the opportunity, creating another element of complexity that firms need to solve for over time to execute effectively.

Time — I’ve pointed this out a number of times already, but in order to execute this model effectively, firms must “ladder up” over many years, building a reputation with others in the ecosystem and gain trust that they can execute effectively with an new, unproven model.

Urban.us has had to prove their seed stage investment chops in urban tech for the last half decade, Bryce Roberts of Indie.vc has almost a 20 year track record of early stage success, and CircleUp is sitting on heaps of data that had to be meticulously gathered and analyzed over the years to make their algorithmic models what they are today.

So another characteristic of successful managers under this model will likely be patience around firm growth, as many strategies will be quite capital constrained thanks to vertical focus areas & time needed to fully capture datasets to allow for useful new capital solutions.

As Chris Douvos put it in a recent Twitter conversation:

The last true risk premium is time. All else has been arb’d away.

To twist the famous words of Andy Grove, “only the patient survive” in the early stage investing market and those providing Precision Capital are in the exact same boat.

Get in Touch!

I am an early stage venture investor based in Paris with a passion for working with companies that elevate human well-being, performance, experience, and opportunity. For the last 3 years, I have been on the team at TechNexus, a Chicago-based firm that invests at the intersection of the venture and enterprise ecosystems.

You can email me at brett [at] technexus.com or find me on Twitter.

The Fourth Edge in Early Stage VC

Behavioral economics has seen its mindshare grow significantly in the investing world over the last decade as more and more people have used it as a primary lens for how to think about decision making.

via fullerthaler.com

In 2000, well after people like Daniel Kahneman and Amos Tversky began making their contributions but before the concepts wrapped inside the field made their way into every corner of the business world, investor Richard Fuller published a paper titled “Behavioral Finance and the Sources of Alpha” that framed the way competitive advantage is gained in investing and identified 3 primary sources of potential market outperformance:

  • Informational — Proprietary access to superior information
  • Analytical — The ability to process information more effectively
  • Behavioral — The ability to take advantage of behavioral biases and mental mistakes by other market participants

Since that time, highly regarded investors, analysts, and operators across the spectrum (like Howard Marks, Michael Mauboussin, and Tim Ferriss) have latched on to the framework and implemented it into their own process.

While the three sources of alpha laid out by Fuller are quite comprehensive in the world of S-1s and 10-ks, they fail to fully encompass the way that alpha is created in the much more opaque and jagged early stage venture market.

Public Markets vs. Venture Capital

For a multitude of reasons, early stage venture capital remains a completely different beast than public market investing.

Despite a playing field that is leveling over time (thanks to Angellist and the like), informational edges are still major drivers of long term success as strength of networks play a key role in which investors see which deals. Additionally, the lack of well understood first party operational performance data for startups and industry-wide benchmarks has provided an opportunity for firms like Social Capital (via its Analytics tool) to aggregate and exploit proprietary data in unique ways.

And while the venture markets and public markets are full of smart people competing away many analytical edges, moving earlier into the private markets offers more opportunities to be “right and non-consensus” by building deep expertise in emerging sectors and technologies that are poorly understood or overlooked.

On the behavioral side of things, both public and private markets (and any other market on earth) will be ripe for taking advantage as long as humans are key actors. If you need more convincing on how often smart people make bad decisions, I encourage you to spend some time digesting Charlie Munger’s thoughts on the psychology of human misjudgement.

As noted above, while these factors largely encompass the forms of potential competitive advantage in the public markets, they do not entirely cover the path to outperformance for early stage venture investors.

The Fourth Edge

Because the start conditions and early trajectory of a business plays such a major role in where it ultimately ends up and since the right relationship with a single hire, customer or commercial partner can have an outside impact on emerging companies that are desperately seeking product-market fit, there exists a fourth key source of alpha in the world of venture capital that investors have long sought to exploit: Strategic

This started with the Kleiner Perkins “Kieretsu” and evolved to today’s platform and services models pioneered by the likes of First Round Capital and Andreessen Horowitz. Other firms have taken more focused approaches to delivering strategic value to their portfolio companies and, by extension improved investment performance to their LPs. SignalFire’s technology-enabled hiring platform is a good example of this.

At TechNexus, our twist on strategic advantage rests in deep relationships with leading corporate partners across the industrial world who serve as both capital and commercialization partners for the early stage companies we back.

This is true whether we are talking with pre-launch companies looking for the right market to take their technology to or companies further down the path who need to prove value in an adjacent space in order to get in position for a strong Series A round.

Prior to even writing a check, we spend a significant amount of time with each founding team building a clear business case and execution plan for the proposed strategic relationship and leverage a tight feedback loop with the technology and business teams inside our corporate partners to validate the plan. In every case, and before taking an investment from us, we want the teams we back to have a clear, measurable understanding of the value we plan to deliver and a process for keeping everyone at the table (the corporate, the venture, TechNexus) accountable and engaged over the course of the relationship.

This strategic-first approach is our specific edge that allows us to be proactively helpful to the founders we back and the execution team we have built to scope and implement these plans gives us the operational bandwidth to make an impact on each startup we work with.

A Unique Strategic Advantage

As with any source of business advantage, competition (some credible, some less so) eventually moves in looking to stake a claim. This is no different than what has happened in the world of venture capital, which is why “value add investor” has entered the realm of overused, vapid business jargon alongside time tested favorites like “double click” and “win win”.

While firms like First Round and Andreessen Horowitz undoubtedly execute at a higher level than most, many other firms talk a good game despite a structural inability to perform on a similar level and deliver real value across an entire portfolio.

Most firms active in the pre Series A market — especially emerging firms — lack the financial and operational bandwidth as well as a specific strategic edge to take a proactive approach to supporting (and driving real value for) companies during the search for product/market fit.

Put slightly differently, it is tough to build a “platform” with $400k/year in management fees.

Instead, these firms fall into what I’ve previously called the trap of the Steph Curry Fallacy, which is to say that they copy the obvious things about what makes the First Rounds and A16Zs of the world successful without doing the work to dive deeper and develop what could become their own unique strategic edge.

For a long time, investors talking in broad strokes about being “value add” got a free pass, but the runway on that seems to be running out. Today’s founders have learned to see that messaging for the noise that it is and have become more savvy about getting to the signal of what makes a firm or specific investor unique as they determine who they want to work with over the long term.

Thinking Slow, Deciding Fast

A one-year-in framework for operating as an early stage investor


The Footnote is a series of audio annotations on some of the interesting things I’ve come across recently on a wide range of topics — from decision-making and investing to technology and the impact it has on the way we work and live.

These episodes are a semi-dive deep into something I’ve written, a topic I want to write about, an interesting article or piece of research, or a recent idea I’ve been kicking around. In each installment, we’ll aim to pull on different threads and explore new angles to help better understand the concepts presented and more thoroughly develop our thinking on the subject at hand.

You can subscribe to The Footnote over on Bumpers >>>

Thinking Slow, Deciding Fast

In the first episode of The Footnote Podcast, I thought it would be useful to talk a bit about what I have learned in my first year on the investor side of the table after spending most of my career on the other side — helping build startups in various business and product roles — and explore the quick framework that I’ve developed around how to operate as an early stage investor.

This framework, which I call thinking slow, deciding fast informs the way I approach two of the more important aspects of my job — building conviction on a company as I am thinking about whether or not we should invest and building a relationship with the founding team during that period where we are coming to a decision.

In a lot of ways, this phrase — think slow, decide fast — is like a mediation mantra…those mantras help recenter you when you find yourself slipping and losing focus. This is essentially the same thing. If I find myself thinking or behaving in a way that contradicts this framework, I try to recenter and approach the situation from a different angle.

Second Level Thinking

The phrase that I’ve mentioned…again, thinking slow and deciding fast, likely calls to mind the book by Daniel Kahneman called Thinking, Fast and Slow. It is a great read and definitely informs the approach I have taken. The central thesis in the book is around the dichotomy between two modes of thought: “System 1” is fast, instinctive and emotional…basically lizard brain type of thought; “System 2” is slower, more deliberative, and more logical.

Another person who has latched onto the “two modes of thinking” concept is Howard Marks — an investor at a firm called Oaktree Capital. Howard has become well-known for both his outsize investment returns as well as his well-constructed investor letters…similar in a lot of ways to Warren Buffett

And, the way these two people — Kahneman and Marks — have laid out their beliefs has been very helpful for me in framing my investment strategy.

Thinking slow, the first part of the phrase, is all about building conviction on investment opportunities, which seems to be one of the toughest things about being new to investing. In my case, I went from the startup side of the equation where you are literally desperate for any opportunity that comes your way to the investor side, where I may look at 300 companies before our firms makes a single investment. So because you are drinking from this kind of fire hose early on in your investment career, people tend to fall back on these very surface level indicators to make decisions:

  • Oh, Bla Bla Bla Capital is investing, they are really smart so I can’t miss out on this deal
  • Oh, the team went to some prestigious school so I should be impressed by them by default
  • Or, oh this is the hot new technology area that everyone is talking about, we have to be active in this space

Of course, these are all important elements of making an investment decision — you want to work with a team who has the chops to pull off what they say they are going to do, you want to have other smart, committed partners in the business, and you want to be investing in technology areas or markets where there is significant opportunity.

But thinking slow is about not taking these things simply at face value. It means:

  • Employing something like the Toyota Five Whys framework — a series of 5 questions, each building off the last and delving further into the problem.
  • Or, as Marks notes, exercising caution if you are operating in a space that everyone else likes…a “hot” area so to speak…if tons of capital has already poured into a segment of the market, it is possible that it is already thoroughly mined and that prices/valuations likely reflect the “hotness” of the vertical.
  • And finally, understanding the incentives of your potential partners — just because some super smart investment firm is involved in a deal doesn’t mean you should be by default…their portfolio is constructed differently, their strategy is different, they may be more or less sensitive to valuations, etc.

So that has been my approach on the actual investment decision side of things, on how I build conviction on an investment opportunity.

Deciding Fast

Another important piece of my work as an investor is on building and maintaining strong relationships with the founders and teams we are working with. And this is where the “deciding fast” part of the phrase comes in…it doesn’t really have much to do with the Kahneman and Marks System I / System II stuff but it helps make the title sound more interesting.

A friend of mine who is also an early stage VC said over dinner the other day that by the time they get to the point where they want to build a financial model or do some kind of in depth returns analysis on an individual deal, it is a strong signal that they want to invest…at the seed stage, and even in some cases at the A stage, there is a limited amount of quantitative work you can do. So in most cases, they just make the decision then and there. And that is exactly what this idea gets at.

Having been on the other side of the table for most of my career, I know that startups don’t have much leverage in any of the conversations they have — customers can squeeze them on pricing, potential job candidates have offers from other companies with better compensation, and investors often have a bit more leverage in negotiations…in many cases, decisions get made wholly on the investor’s time table.

There was a survey done a couple of years ago by Point Nine Capital’s Christoph Janz that found the #1 most frustrating thing for founders about fundraising was not knowing where they stood in the process.

So one of the big things I try to do is make sure that whenever I make a decision or get some type of “news” on a company — whether it is a decision to move them forward in the process, to say no, to present what they are doing to the broader team, or if thereis some kind of delay — is make sure I communicate that clearly and in a timely fashion to the founders.

So there you have it…my 1-year in framework for trying to do my job as a venture investor well:

Build conviction by trying to think deeply about the levers that truly have an impact, know when you have enough information, make your decision, and clearly communicate that to the people you are dealing with.

Sounds simple but in my experience has been anything but.


Taking the Pulse of the Seed Stage Market

Venture funding into startups dipped significantly in the first quarter of 2016…yet venture funds themselves raised more money than they have in a decade. So where does that leave us today, specifically as it relates to the seed stage market?

We looked at four factors — current seed stage availability, follow-on capital availability, the M&A market, and the historical economics of seed investing — to gauge where things stand today and help investors build a strategy for the current environment (Spoiler: We think the argument for allocating capital to the seed stage remains strong).

1. Seed Capital Availability

At first blush, a funding dip like the one experienced by the seed stage in the first quarter of 2016 seems disconcerting, especially for angel investors or micro VC funds simply interested in participating in (and not leading) deals. If others don’t show up and fill the round like expected, investors could conceivably be left holding the bag on a doomed investment.

The more likely reality is that the most recent 2 or 3 trailing quarters were simply a slight reversion to normal levels and the pace will continue at a strong clip for the foreseeable future. The last few years have seen funds focused on the seed stage raise a historically outsize amount of capital, much of which remains ready to deploy. And despite some handwringing early in the year about a sinking public market derailing the private market, much of that concern — rightly or wrongly — seems to have been brushed aside.

2. Follow-on Availability

If you have been following the seed stage market with any intensity for any period of time — 1 day or 1 decade — you’re sure to have heard about the almost-about-to-happen Series A crunch. Essentially, as record levels of capital have poured into the earliest stages — via accelerators, individual angels, and the hundreds of seed funds that have been raised in recent years — onlookers have feared that a capital mismatch would take place and a more than usual number of those seed funded startups would be left to wither and die on the vine.

To an extent, this started coming true late last year, as Mattermark data showed “graduation rates” (Seed funded companies that go on to raise Series A rounds) continuing their already downward trajectory in 2015.

Ultimately, the success of an early stage venture portfolio is dependent on whether companies within that portfolio are able to achieve exits via acquisition or IPO. When investing at the Seed stage, however, exits can take half a decade of more. This makes those graduation rates that we mentioned above a very important metric for early stage investors to track and have a handle on.

The concept is pretty simple. If companies in your portfolio continue raising capital, they continue to survive and are more likely to eventually experience some sort of liquidity event.

In Q1, a majority of the capital raised was concentrated among a few firms, most of whom invest across stages but allocate a investment dollars to mid and late stage companies. This bodes well for the current and upcoming crop of seed stage startups who will be in the market for further raises in 12–24 months time. Beyond that time frame, we look to our next factor…

3. The M&A Environment

Q1 2016 saw exactly zero venture backed IPOs. Add to that the fact that the software sector — where most venture capital flows — saw the lowest number of exits since 2011 and it is pretty clear that the M&A and IPO markets can’t get much worse then they are now. As we noted above, private follow-on rounds are great…but the real returns for investors come when some sort of liquidity event occurs. And while it is possible that the IPO window may remain firmly closed for the foreseeable future, other factors indicate we may be in for a pickup in M&A activity in the industry.

  1. The Facebook Effect — In recent years, Facebook has become as well known for its purchased properties — What’s App, Instagram, Oculus — as it has for its core app. This acquisitive approach gives the company the ability to buy the future (before it becomes too large and thus desires to stay independent) instead of building it. Large corporates are nothing if not copycats so expect to see a few others follow Facebook’s lead and step on the acquisition gas pedal here shortly.
  2. Corporate Venture on the Rise — This piggybacks on the Facebook Effect, as corporations have record levels of cash on hand and have realized that true innovation is unlikely to come from within. Since 2011, the amount of corporate venture capital — both in gross and relative terms — has steadily crept up. As those portfolios mature, it becomes more likely that corporate acquirers will be eyeing a few of the top performers.

4. The Economics of Being Early

This last factor is one that has not been significantly impacted by recent funding patterns but remains important nonetheless. Per data from Cambridge Associates, relative to other stages of the private venture market — and frankly to almost all other asset classes — the seed stage outperforms.

This outperformance was brought to back to the surface recently in a series of Tweets from Horsley Bridge Partners, a prominent LP who has backed many of the industry’s top firms. The firm analyzed over 5,500 realized deals from across their portfolio to understand the risks and rewards of early stage and late stage investing. To pull a page from venture darling Buzzfeed’s book…what they found will shock you! We will let the Tweets speak for themselves.

While we spoiled our conclusion above, it makes sense to reiterate here. Capital is available — both at the seed stage and in follow on rounds — for good companies and that availability will continue for the foreseeable future with the amount of dry powder sitting in the bank accounts of both early and late stage investors. On top of that, M&A headwinds are strong (well, stronger) than they have been and the economics continue to favor investors who back companies early in their lifecycle.

Originally published at institute.seedchange.com on April 28, 2016.