Now that our seed fund Homebrew has past its first anniversary, people often ask what has surprised me during my year as a VC, or what am I liking/disliking about my new profession. My answers are actually bland, largely because I had a pretty good handle on what the initial 12 months would bring and a great partner in Satya Patel. One question I did spend time on before we started Homebrew and throughout the year is “What mistakes do new VCs usually make and how could I avoid these common errors?” Sourcing feedback from LPs, VCs and entrepreneurs, here’s some of what I heard, and the implications:
1. Too Disciplined/Not Disciplined Enough
Congrats, you’ve raised a venture fund by telling your investors about the plan you want to execute. And then a little thing called “reality” hits. Not every company is raising money at the valuation you modeled. There are good opportunities on your plate which don’t exactly fit in the markets you thought you’d be focused. The strategy you suggested was just perfect needs some tweaking. Do you blindly stay the course because you want your investors to praise your “discipline?” Or do you start lurching towards every apparent opportunity because heck, if you make them a ton of money they won’t care about your discipline?
Obviously the right call is “neither” but many VCs can be frozen by this question. My answer for what “discipline” means at Homebrew and how to navigate changes in strategy came from two sources. First was one of our major investors who told me (paraphrasing) “We know you’re building a new fund and it will take time. We expect that you’ll be responsible but also will see opportunities which weren’t apparent before you began. You should take some of these bets and know we’ll support you. We’ve outsourced our judgment to you and trust you.” Now some folks might roll their eyes and say, “sure, they’ll trust you until you fuck up and then it’s all ‘why did you do this or that'” but we were very focused in our fundraising to find LPs that matched our longterm goals.
The second counterbalance was our own partnership dynamics. We think of Homebrew as our startup, just one which writes checks instead of code. Accordingly we seek to learn and iterate quickly, not just wait to see how our fund does. One example of a change we made during Year One was in how we approach ownership targets. We started the fund with a strict minimum ownership target corresponding to our investments – ie “based on our seed investment we minimally want to own x% of a company.” After about six months or so we realized that this was too blunt a way of expressing what we were really trying to accomplish: the concentration of our capital in a meaningful enough way to share in the upside of investments that performed really well.
So we changed our approach to a more deliberate question of “how much do we think we need to own of this company to get to a [target return amount].” Now it turns out that we were still around ~10% for many subsequent investments but two interesting outcomes also occurred. One, we started looking at some investments where round dynamics meant we might have owned ~8-9% but the outcome potential was significant enough to still make our target. Second, we did an investment where we actually decided to own more than 10% because of the nature of the business model. Obviously too early to understand whether our changes made sense but we felt like they were appropriate based on market feedback and our goals in working with the best entrepreneurs.
2. Waste Too Much of Entrepreneurs Time
Eager new VCs often want to look at every deal they can see and can overtax entrepreneurs asking for more time, data, diligence without ever pulling the trigger. During Homebrew’s first few months we requested more “second meetings” than we should have. Not a ridiculous overage (as our dealflow stats show) but we could tell something was a bit off. Discussing this, Satya and I realized that we were still finding our own groove and filters as a partnership. It was always easier after a promising first meeting by one of us to say “hey, take a look at this” and both meet with the company. We were always earnest in our interest and since our default engagement mode is to give feedback, I’d like to think that these meetings were of some value to the founders, but in more of these cases the initial partner should have applied more rigor and conviction.
Our goal though is to move as fast, or faster, than the entrepreneur while making best use of our collective time to get to know each other. So we changed our process a bit to the three stage approach I outlined earlier.
3. Imagining You Can “Fix” a Team/Product/Market
New VCs, especially those with an operating background, can see a company for what they want it to be rather than what it is. They use their own brain to fill in the blanks on an opportunity versus really understanding how the founders think. They imagine sure the product is a little raw but if they invest and spend a few hours a week with the team, it’ll be okay because they can fix it! There was an old saying that it took $50 million to train a VC (ie you don’t really know what you’re doing and if you’re good until you’ve made a significant number of investments). Considering that’s larger than our $35m fund, you could imagine that I wasn’t too interested in proving the axiom correct.
Fortunately this was one of the places where several years of angel investing taught me well using smaller checks out of my own pocket. With no exceptions, my worst bets were in companies where I either relied upon social proof or where there was a gap between founder vision and ability to execute that I thought investors/advisors could bridge. While not perfect, these experiences helped tune my radar before Homebrew invested Dollar One.
4. Chasing Hot Markets
New VCs are vulnerable to fashionable verticals. What are some motivations to chase the market? Groupthink certainly; high volume of new companies in these spaces; perceived appetite for these companies from downstream investors mean you can get some quick markups over next 12 months. Remember a few years ago when every VC seemed to want to back their own “something sent to you each month in a box” companies?
For a seed stage fund like Homebrew, chasing hot markets seemed like madness. First, mass enthusiasm was likely a lagging indicator given where we want to invest. Second, they often attracted purely opportunistic founders who lacked the mission-driven mindset we wanted. Our strategy isn’t to necessarily be contrarian but we decided there were certain verticals that we weren’t going to pursue in 2013. For example, food delivery. Operationally complex, low barrier to entry, lots of funding in the space, not particularly capital efficient, a number of companies seeded prior to our fund being created and so on. Were we right to hold back last year? Some recent follow-on financings and company momentum would suggest there was paper value we left on the table but (a) it’s still very early and (b) as Fred Wilson says, small funds need to focus on getting just a few ideas correct, not being in every deal.
5. Not Understanding Portfolio Management
Venture is a cash flow business, although many outsiders don’t think of it that way. You have a fund to invest and you’re likely reserving the majority of it for follow-on. You’ve got dollars to draw down but also likely recycling (meaning you’ll reinvest profits until your capital deployed is equal to the actual amount raised). At any given point you’re making decisions about the size of the portfolio you’re trying to hit, the capital you want to deploy in initial checks, how much is reserved for follow-on at a company by company basis, paying management fees, increasing/decreasing fund expenses and so on. Many new managers who lack previous professional investing experience don’t realize how important these aspects are to a successful fund. And it’s more downside than upside. That is to say, doing this correctly isn’t going to help you create a 10x fund but messing up can definitely handicap you in delivering strong returns.
My strategy here was: rely on others! I’m lucky enough to have the support of great LPs who provide advice, a back office service that’s best of class, other VCs who have been generous with the advice and most importantly, a partner who has been at a fund before. If you ever find yourself in Year One of VC, whether at your own fund or an existing entity, make sure to understand these operating details and get some help.