Teaching Venture Capital to LPs

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When I was first exposed to it in the mid ‘90s, venture capital was a different business. Back then, the mystique surrounding a venture capitalist was minimal. VCs were mostly successful tech entrepreneurs who decided they wanted to do something a little different. They weren’t following some sort of thesis that involved “odds,” they weren’t on Twitter giving advice, and they weren’t chasing unicorns. It was a simpler time focused on profitable growth and making every investment count. And the biggest difference that I have seen today is in the level of due diligence performed. 

We have a slide in our investor deck that says, “we are investors, not gamblers.” When I first read this, I thought it was unnecessary to state it. It seemed obvious. But my team reminded me of several conversations we’ve had with LPs (Limited Partners) in the past, and why we needed to state it again. Our experience has been that we have to either take financial investors (who are already familiar with VC) and teach them about the opportunities in built environment technology, or we have to take strategic investors (who are familiar with the built environment and the opportunities in related technology) and teach them about venture capital. 

Much of our strategic LP base is from the real estate industry. They have somehow been convinced that venture investing is different from real estate investing, and they don’t “get it.” It is fascinating that these very experienced and successful people have been convinced that they can’t understand venture investing. Later this month, I will be running a roundtable to teach some of these folks more about VC. Venture investing isn’t magic; it is just WORK.

The biggest task with our strategic LP base is reframing their thinking on venture capital. For some reason, people think that venture capital looks like Shark Tank. A product is presented and the investors give immediate reactions and may even get into a bidding war. And for some VCs, that’s not far off. My hypothesis has been that venture capital has shifted from doing the work to using the “spray and pray” method. This gambler’s approach is supported by “facts” that some VCs espouse as their theories around selection criteria. Selection criteria can be great for the top of the funnel, but not as a method of due diligence. This shift is one of the reasons that venture capital is broken.

I recently did a Twitter poll. I know it is not the most scientific method, but it does give me a certain data set to observe. For context, I have just under 4,000 followers. They are mainly other venture capitalists, startup entrepreneurs, and built environment professionals (architects, engineers, contractors, and real estate professionals). I asked everyone how many hours they think a VC puts into due diligence, on average. The results of my poll were interesting. 42% believed that VCs spend less than 100 hours on due diligence. I was surprised by this. My colleagues were surprised that I was surprised. 

We have determined that we spend about 400 hours to due diligence a deal at our firm. This doesn’t include sourcing, but everything from the pre-work to getting a reasonable term sheet in place to actually closing the deal. This is why we have a team. The reality is that we lose money on our management fees. We primarily have to make money off of our carried interest. In my mind, this aligns our interests with the interests of our LPs. So when we see a firm of 10 people making 100 investments, we figure that they can’t possibly be doing the actual work required. 

I do agree that doing the work doesn’t remove risk, but it does mitigate it. Just because it doesn’t remove risk completely doesn’t mean you shouldn’t do the work. That would be the equivalent of a real estate investor not walking a property before purchasing it. 

When my 17-year-old son was 13, he related what I did for a living to those house flippers on TV. Except with startups. He said I find startups that are in a great market, I put some money and effort into them, and then I sell them to someone who wants to “live in the house” forever. If you watch those shows, at the end they walk through the math of how much money they made or lost. Typically, they lose money due to unforeseen circumstances or because it took longer than they expected to sell the house. When my investments have gone poorly, this is exactly what has happened. 

However, the norm in venture capital is to write off the dogs and move on. Since we are operators, we are a little different. We will always do the work to try to recoup our investment. Can you imagine walking away from a real estate investment that wasn’t performing because it wasn’t worth your time anymore?