Competing in the Venture Capital Industry

Competing in the Venture Capital Industry
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There's an unequal distribution of power in the venture capital industry: The best firms get the best deals and the best deals provide disproportionately higher returns.

The best deals are super competitive to get in to. Naval Ravikant has said VCs don't have proprietary deal flow, they have proprietary access. VC firms will compete for access.

Venture capital is actually a fairly competitive industry. It's a tough industry to be in if you're not at the top. But if you are, it can provide incredible returns.

As companies get cheaper to build, there is becoming less need for venture capital. Power is shifting to the entrepreneurs. VCs will need to adapt and differentiate themselves to stay competitive, just like firms in any other industry.

I suggest the following as ways for firms to improve access to deals:

1. Overpaying for the best deals

To quote Paul Graham, "high returns do not come with companies with low valuations." The valuations are high because so many investors want access (supply and demand). And as we know about the venture business, the top deals will provide disproportionately higher returns. So it would probably be good to get access to those :).

Companies like higher valuations because the higher the valuation, the more the equity of the existing investors and employees at the company is worth. So they may be more willing to give access the the firm offering the higher valuation

The potential downsides of overpaying are:
If you overpay by too much, your returns will be lower even if the company is a huge success.

If you have a syndicate of other investors who want to do the round at a lower valuation they might back out. This could put the firm in a difficult position of trying to collect a new syndicate, or covering the entire round. This is a situation where a larger fund could have an advantage over a smaller fund. They might be able to price out the smaller firms and cover the whole round.

Pricing up a round could potentially hurt the company later on. If the company doesn't meet objectives to justify that valuation, it could lead to them having to raise a subsequent round at a flat or lower valuation. Which leads to dilution and bad signaling.

2. Building a strong reputation for being great to work with

There are many ways for VCs to help their portfolio companies: advice, introductions, intel on competitors, being available for calls and meetings, etc. With sites like TheFunded, having a good reputation with entrepreneurs is increasingly important.

First Round Capital has taken this to a new level by building an internal platform including a team of operators to assist portfolio companies.

3. Being helpful and proving value before reaching a deal

I believe the best way to convince someone is to prove it. Instead of telling the company they will provide expertise and connections, they can start doing so before the deal is closed. That way the entrepreneurs know how helpful the firm will be. Good connections are always mutually beneficial, so even if the deal doesn't work out, at least they've the other party in the connection.

4. Mentoring and advising startups before they're at a stage where they're investment ready

Relationships take time to build and are very important in business. If the VC starts adding value and building trust before a company's at a stage that meets the VC's criteria, when the company is read for investment, that particular VC may be the first firm they ask to participate.

The downside is that it could potentially be too time consuming and take away from the VCs other responsibilities (deal sourcing, due diligence, supporting existing investments, raising more money from LPs, etc).

5. Making quick decisions

Fundraising can be extremely time consuming for a startup's management team, so it's important for them to close a round as soon as possible so they can get back to growing the company.

To be helpful, VCs could put effort into offering a term sheet quickly. Being faster to say no could also help build a reputation as a good firm to at least pitch to.

The potential downside is that without sufficient diligence important data needed to make an educated investment decision could be missed.

6. Offering Founder friendly term sheets

In a similar vein to overpaying (valuation is a term on a term sheet), providing more founder friendly terms than other VCs may make a company more willing to give a VC access.

7. Increasing transparency

Naval Ravikant proposed a "Venture SLA" to improve firms' transparency. "A Venture Capital Firm that voluntarily constrains itself will be viewed as Founder Friendly, Smart Money, and will never be short of opportunity." It would make it easier for both sides to get deals done. As Naval states, VCs could get away with the lack of transparency and vague value propositions, but as competition increases and demand for capital declines, this is becoming less viable.

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