About funding – The denominator effect | by Mark Sister

Entrepreneurs News

Mark Suster

I recently wrote a post about investing for investors to think about a diversified portfolio, which I called “shots on target”. The thesis is that it is almost impossible to know which of the trades you have made will break out to the upside before investing in an early stage start. It is therefore important to have enough offers in your program so that the 15–20% of great offers can emerge. If you funded 30–40 transactions, perhaps only 1 or 2 would drive the largest returns.

You can think of a shot at target as the counter in a fraction where the counter is the actual transactions you have completed and the denominator is the total number of transactions you have seen. In our funds we do about 12 transactions per year and see several thousands so the funding rate is somewhere between 0.2–0.5% of transactions we evaluate, depending on how you count what “evaluation of a transaction” entails.

This is venture capital.

I want to share with you some of the most consistent pieces of advice I have given to new VCs in their careers and the same advice applies to angel investors. Focus a lot on the denominator.

Let’s assume you’re a fairly well-connected person, you have a strong network of friends and colleagues working in the technology sector, and you have many friends who are either professional or individual investors.

Chances are good that you will see very good deals. I would be willing to bet that you will even see many transactions that look incredible. In the current market, it’s not that hard to find executives leaving: Facebook, Google, Airbnb, Netflix, Snap, Salesforce.com, SpaceX… to name a few – to start their next business. You will be engineers from MIT, Stanford, Harvard, UCSD, Caltech or drivers from UCLA, Spelman, NYU, etc. find. The world of talented people from the top companies and top schools is literally tens of thousands of people.

And then add these people who have worked at McKinsey, BCG, Bain, Goldman Sachs, Morgan Stanley and what you will have are not only truly ambitious young talent, but also people who are good at doing presentation decks full of data and maps and what perfected the art of narrative storytelling through data and predictions.

Let’s now assume that you take 10 meetings. If you are fairly smart and considerate and in a hurry to get in front of big teams, I feel very confident that you will find at least 3 of them convincing. If you’re in front of big teams, how could you not?

But let’s now assume you’re pushing yourself hard to see 100 trades over a 90 day period and as many teams as you can meet and not necessarily invest in any of them, but you are patient to see how amazing really looks like. I feel confident that after seeing 100 companies, you will have 4 or 5 that really stand out and that you find convincing.

But here’s the rub – almost certainly there will be no overlap of those first three transactions you thought were high quality and the 4 or 5 you’re now ready to punch on the table to say you should finance.”

Ok, but the thought experiment needs to be expanded. Let’s say now you’ve taken a whole year and seen 1,000 companies. There is no way you would advocate financing 300-400 hundred of them (the same ratio as the 3-4 from your first 10 transactions). In all likelihood, 7 or 8 transactions will really stand out as truly exceptional, MUST DO, hit-your-first-on-the-table type transactions. And of course, the 7 or 8 deals will be different from the 4 or 5 you first saw and were ready to fight for.

Gambling is a numbers game. So is angel investment. You have to see a lot of offers to start distinguishing good from great and wonderful from truly exceptional. If your denominator is too low, you will be financing transactions that you considered compelling at the time that would not succeed with your future self.

So my advice comes down to these simple points:

  1. Make sure you see tons of offers. You need to develop pattern recognition for how truly exceptional it looks.
  2. Do not be in a hurry to make transactions. The quality of your transaction flow will almost certainly improve over time, as well as your ability to distinguish the best transactions

I am also personally a big fan of focus. If you see a FinTech transaction today, a Cybersecurity transaction tomorrow and then creator utilities the next day… it’s harder to see the pattern and have the knowledge of truly exceptional. If you see every FinTech company you can possibly meet (or even a sub-sector of FinTech like Insurance Tech company … you can really develop both intuition and expertise over time).

Get lots of shots on goal (completed transactions, which is the counter) to build a diversified portfolio. But make sure your chances come from a very large pool of potential transactions (the denominator) to have the best chances of success.

Photo credit: Joshua Hoehne on Unsplash

Source link

Leave a Reply

Your email address will not be published.