Categories: Startups

On Funding — The Denominator Effect

I recently wrote a post about funding for investors to think about having a diversified portfolio, which I called “shots on goal.” The thesis is that before investing in an early-stage startup it is close to impossible to know which of the deals you did will break out to the upside. It’s therefore important to have enough deals in your program to allow for the 15–20% of amazing deals to emerge. If you funded 30–40 deals perhaps just 1 or 2 would drive the lion’s shares of returns.

You can think of a shot on goal as the numerator in a fraction where the numerator is the actual deals you completed and the denominator is the total number of deals that you saw. In our funds we do about 12 deals / year and see several thousand so the funding rate is somewhere between 0.2–0.5% of deals we evaluate depending on how you count what constitutes “evaluating a deal.”

This is Venture Capital.

The Denominator Effect

I want to share with you some of the most consistent pieces of advice I give to new VCs in their career journey and the same advice holds for angel investors. Focus a lot on the denominator.

Let’s assume that you’re a reasonably well-connected person, you have a strong network of friends & colleagues who work in the technology sector and you have many friends who are investors either professionally or as individuals.

Chances are you’ll see a lot of good deals. I’d be willing to bet that you’d even see a lot of deals that seem amazing. In the current market it’s not that hard to find executives leaving: Facebook, Google, Airbnb, Netflix, Snap, Salesforce.com, SpaceX … you name it — to start their next company. You’ll find engineers out of MIT, Stanford, Harvard, UCSD, Caltech or execs out of UCLA, Spelman, NYU, etc. The world of talented people from the top companies & top schools is literally tens of thousands of people.

And then add on to this people who worked at McKinsey, BCG, Bain, Goldman Sachs, Morgan Stanley and what you’ll have is not only really ambitious young talent but also people great at doing presentation decks filled with data and charts and who have perfected the art of narrative storytelling through data and forecasts.

Now let’s assume you take 10 meetings. If you’re reasonably smart and thoughtful and hustle to get in front great teams I feel highly confident you’ll find at least 3 of them compelling. If you get in front of great teams, how could you not?

But now let’s assume that you push yourself hard to see 100 deals over a 90 day period and meet as many teams as you can and don’t necessarily invest in any of them but you’re patient to see what great truly looks like. I feel confident that after seeing 100 companies you’ll have 4 or 5 that really stand out and you find compelling.

But here’s the rub — almost certainly there will be no overlap from those first three deals you thought were high quality and the 4 or 5 you’re now ready to pound your fist on the table to say you should fund.”

Ok, but the thought experiment needs to be expanded. Now let’s say you took an entire year and saw 1,000 companies. There is no way you’d be advocating to fund 300–400 hundred of them (the same ratio as the 3–4 out of your first 10 deals). In all likelihood 7 or 8 deals would really stand out as truly exceptional, MUST DO, slam-your-first-on-the-table type deals. And of course the 7 or 8 deals would be different from the 4 or 5 you first saw and were ready to fight for.

Venture is a numbers game. So is angel investing. You need to see a ton of deals to begin to distinguish good from great and great from truly exceptional. If your denominator is too low you’ll fund deals you consider compelling at the time that wouldn’t pass muster with your future self.

So my advice boils down to these simple points:

Make sure you see tons of deals. You need to develop pattern recognition for what truly exceptional looks like.
Don’t rush to do deals. Almost certainly the quality of your deal flow will improve over time as will your ability to distinguish the best deals

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

Get lots of shots on goal (completed deals, which is the numerator) in order to build a diversified portfolio. But make sure your shots are coming from a very large pool of potential deals (the denominator) to have the best chances of success.

Photo credit: Joshua Hoehne on Unsplash

On Funding — The Denominator Effect was originally published in Both Sides of the Table on Medium, where people are continuing the conversation by highlighting and responding to this story.

Source: Both Sides of the Table - Medium

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