Why do venture capital funds often choose emerging technology businesses to invest? Why don’t they invest in classic businesses, wear durable clothes and rest assured that their capital flow will not be lost? There are many questions about who the venture capital funds will be interested in. What these businesses are like and the investment logic of venture capital funds for these businesses is what we will discuss in today’s article.
Part 3: Fast-growing startups.
Classic businesses will typically decide on a market to enter, produce products and services, and then find a way to get their first customers. Gradually increase the number of customers paying for the product. After 3-4 years of steady growth, cost control and gradually increasing profit margins, these businesses continue to compete until the market pie is divided and business owners benefit from their investments. slowly, of course, after about 15-20 years. This type of business will prefer debt financing because their profits are planned to cover reinvestments and borrowed capital is a cheap flow of capital as we know it.
The picture completely changes when we talk about venture capital funds. The goal of success for funds and fund managers is to increase the share of assets they are managing. This goal can only be achieved when the valuation of the business in which they invest increases, and must increase rapidly. From there, the fund can divest by selling shares or IPO. With a life cycle of typically 10 years, funds expect to divest some or all of them in about 3-7 years. This, for the business receiving the investment, means that their growth rate must be outstanding during this time period.
The Venture Capital industry is driven by the hope of finding a handful of successful businesses and that success must be large, resonant and high value. In a portfolio of funds, 10 failed deals can be salvaged by just 1 successful one. A hugely successful megahit deal can accelerate the growth of the entire industry.
These megahits will be called by the beautiful name: “Unicorn”, which are startups with a valuation of over 1 billion USD.
Typically, businesses that are able to meet the criteria (1) high growth rate and (2) ability to expand quickly are enterprises with disruptive innovation capabilities. Like the UBER case has done for the taxi industry.
Today’s technology allows the number of users to grow almost unlimitedly. Social networks are operating with as many users as the population of the most populous countries in the world, something that before, private businesses could not dream of.
The cost to serve a new customer is now almost negligible for the technology industry thanks to the extensive network infrastructure and very high automation capabilities.
Thus, we clearly see that: VCs are unicorn hunters.
However, in reality it is not easy to distinguish a real unicorn from a colorful old horse.
A startup at the same time as the Amazon monument whose name few people remember now. It’s Webvan. Founded in 1996 with an online grocery model, Webvan is one of the pioneers with a post-IPO valuation of only 3 years after its founding of $ 4.8 billion. Webvan went bankrupt just 2 years after its IPO. Many reasons were given, and most of them became lessons for a truly unicorn of the time, Amazon.
Investors for Webvan through the stages include many famous names such as Benchmark, Goldman Sachs, Softbank, Sequoia, Yahoo, etc. Even the super and experienced eyes of the Venture Capital industry are sometimes That’s how old horse and unicorn are confused. However, always remember: failure is part of the venture capital process. Sequoia has also had many admirable tractions such as investing in Google with Kleiner Perkins so that not too many people remember their Webvan failure. To this day, Sequoia remains one of the most trusted VC fund managers.
The venture capital industry exists and develops based on the “Hits Driven” principle, which is very similar to the industries of gold mining, oil and gas exploration, space exploration, music, literature or cinema. Investors in these industries often have to foresee a prospect of success, willing to take the risk to invest money, time, and effort in pursuit of their beliefs. With a little luck, if successful, it will be a great success.
In the literary world, one can take J.K. Rowling as an example for an entrepreneur. The book “Harry Potter and the Prophet’s Stone” was submitted in manuscript to 12 publishers and was rejected. Surely there are founders or pitchers who will understand this pain. When Bloomsbury decided to publish the book, they were like venture capitalists themselves. So far, Harry Potter has remained a bright spot in the company’s portfolio with 13% contributing to 2018’s profits.
Venture capitalists are not interested in a startup with steady profits and slow growth. For us, those are the “walking dead” that, when there are too many in our portfolio, we will never be able to return the investment to our investors, not to mention the increased assets. We are looking for startups with “Hockey Stick” growth potential (as shown). To achieve this form of growth, we will commit to multiple rounds of funding, enough for the startup to hit certain milestones (milestones).
A VC when investing is like launching multiple rockets to the moon (which is when we exit). Fuel will be burned in stages to overcome the atmosphere and the resistance of gravity. Here is each round of funding that we will be participating in. Any rocket that does not reach the moon is considered abandoned. The moon is the ultimate destination with a VC and pretty milestones along the way don’t mean much.
In short, to understand these principles, startups should carefully consider their vision and model to understand what VCs want when they refer to “a startup with high growth”.
Rekindled in the 1950s in the California wilderness that nurtured the daring and the American dream, the venture capital industry is a powerful driver of the rapid development of not only modern business but also of technology and innovation around the world. Today’s tech companies turn to venture capital funds to share ideas, find connections, financial backing, and strategic perspectives.
Understanding the historical origins, investment motivations, profit expectations and day-to-day operations of Venture Capital VC (Venture Capital VC) management companies is a key factor in helping (1) innovators have an appropriate fundraising strategy, (2) traditional investors have more new investment approaches and (3) policymakers have an effective way to attract investment in the context of closed technology. role in promoting the economy. The series of articles on UNDERSTANDING VC FUND aims to provide official perspectives on the venture capital industry and analyze related factors, serving the three groups mentioned above.
In each part of the world, depending on the level of economic development, the quality of enterprises and government policies, VCs will operate in a number of different ways and serve different audiences. Essentially, however, a venture fund will (1) raise capital from other institutions to (2) invest in the equity of (3) small and medium-sized enterprises (SMEs) or Startups that have a high growth rate.
Part 1: Capital of VC
VC management companies (venture investment firms) do not use all their own money to invest, but they are professional capital managers, using the capital of many other organizations to make profitable investments.
Partners investing in VCs are usually organizations such as:
Pension Fund: Usually a state fund and manages employees’ pensions. These funds are familiar partners of VCs, especially in the Euro area due to their ability to unify several technology and sustainable development goals. Not many Southeast Asian VCs have access to this fund. AP4 and AP6 of the Swedish government are among the funds that coordinate the most capital into VCs today with about 11% to 15% of total assets under management (Asset Under Management AUM).
In our view, to promote innovation and effective investment, countries in the region need to expand the possibility of cooperation between pension funds and VCs. This needs thorough research, relevant human resource training and institutionalization to increase the efficiency of this capital management.
University Endowment: University endowments contribute to the development of fundamental scientific research. These funds, along with a wealth of knowledge from the university, are the basis for increasing the ability to connect and solve problems of the companies in the VC portfolio. In 2019, UE’s investment in VCs was rated as the most effective, bringing an average return of 13.4% per year, according to The National Association of College and University Business Officers – 2019 NACUBO-TIAA Study of Endowments.
The majority of universities in the region focus their cash flow on optimizing infrastructure and research activities, we do not have enough long-standing and sustainable capital flows like Western economies to increase the rate. contribution rate to the UE from which to navigate into the VCs. The most successful case of this type of fund is the National University of Singapore Endowment, which invests in the style of Yale University: long-term, diversified assets, diversified foreign currency sources and global investment audience. This fund also only spends 20% for equity investments, a very small part of which is VC.
Banks: As a risk-sensitive group, banks have maintained a very small amount of their capital invested in VC funds throughout the industry’s history. Currently, some banks like Goldman Sachs invest directly in startups such as the recent case of leading Series C $ 81 million in fintech startup Amount based in Chicago, IL. Banks are interested in FinTech startups because of the possibility of strategic cooperation rather than direct profits. The investment banking group makes a more prominent contribution to the VC industry in IPO listing activities than an investor.
Asian banks in particular have not yet applied much interaction with VCs to their operations. The main reason is that the risk tolerance of both well-trained bankers and financial policy makers is not high. This market has also witnessed many financial crises that have had a lasting effect that has caused the investment behavior of the majority to remain oriented towards traditional and low-risk options. Moreover, the number and quality of startups in the region is not as high as in the West.
High Net Worth Individuals (HNWI) and Family Offices: European VC funds often source funds from Middle Eastern oil billionaires due to historical ties and the lack of specialized fund managers. industry in this area. However, managing relationships with many of these investors consumes a lot of VC resources. Large VCs tend to raise capital from a small number of large investors rather than many HNWIs. Small VCs will typically raise HNWI funds until they have the reputation and experience to raise money from larger partners. Some of the celebrities such as Jared Leto, the Joker in Suicide Squad, the lead singer of the band 30 Seconds to Mars, have an impressive portfolio that includes Uber, Airbnb, Spotify, Nest, Reddit, Slack, Snapchat.
HNWIs in Asia are quite large and the amount of money they have is enough to create a very good motivation for VCs and startups. However, the majority of HNWIs have the need to invest in U.S. regions to benefit from immigration policies as well as more trust in Western fund managers. The HNWIs in the region themselves reap the same amount of capital from traditional industries, leaving a gap in trust between them and the tech VCs.
These organizations/individuals when contributing capital to VC will be called Limited Partners (LP).
Some VCs formed by founders who have successfully exited startups will tend to use their own cash flow to generate initial capital for that VC. For example, VC Andreessen Horowitz was founded in 2009 with an initial AUM of $300 million from Marc Andreessen after divesting from Netscape.
An important principle for minimizing investment risk is portfolio diversification. This principle is stated as “never put your eggs in the same basket”.
The organizations mentioned above have large resources that need to be managed. In addition to investing in the traditional bond and stock markets, they have a need to put a small portion of their funds into high-risk alternative assets with high return expectations. such as Hedge Funds or Private Equity funds, of which VC is one of them.
Typically, the portion of capital authorized or contributed to VCs will account for about 2-5% of the total AUM. However, this proportion is increasing because of the interest in the impact of technology on national development and successful divestments of VCs. Sweden’s AP6 pension fund currently maintains an 11% share of its $2 billion AUM to invest in VCs. One successful case of this fund is music and media platform Spotify through VC Northzone.
In addition, pension funds have a long life cycle, which is very suitable for the life cycle of VCs, most of which are 10 years.
WHAT DOES VC GET WHEN MANaging MONEY FROM THESE ORGANIZATIONS?
VCs usually charge fees with the “2 and 20” principle. 2% annual management fee on the total AUM and 20% performance fee (Performance Fee or Carried Interest) based on the total growth of the VC fund. Depending on the market and the strategy of the VCs, this fee may change. Compared to some other sources of capital, especially loans, VC is considered an expensive source of capital. However, LPs always know that this industry requires thoroughness, high concentration, practice with companies in the portfolio and a system of specific knowledge and skills. That’s why LPs still trust and more and more VCs are born.
In order to ensure the interests of the LPs, the VC is subject to legal constraints related to the obligations of the trustee (Fiduciary Duty). In this case, the VC is entrusted to manage the funds owned or raised by the LPs according to a number of purposes and scopes agreed between the parties. This legal constraint forces VCs to perform their professional obligations in the best possible way, serving the interests of the LPs. In the opposite case, the LPs can sue the VC in court and the individuals who commit the wrongdoing will have to pay compensation depending on the damages. However, the publicity of the lawsuits is relatively low, and the parties involved often choose to negotiate to resolve the issue. The biggest price VC has to pay is not being able to raise new capital sources if it shows poor fund management and profitability.
In part 2, we will analyze the equity-only characteristics of VCs and their expectations during the investment process.
Throughout the history of the financial industry, the currency has always been under pressure to depreciate due to inflation and must create a surplus from its own value through financial activities. In order to make a profit on the capital you manage, you have many options such as lending at interest, investing in other funds, buying stocks, buying government bonds, buying oil or rare metals, etc., if you are managing a venture fund, you will primarily invest in the equity of a startup.
Part 2: Investing in business equity
When a VC invests in a business, which is mostly high-growth startups or owns technology that promises future outperformance, the VC buys the equity in that business. That is also why startups that are oriented to raise capital from VCs should set up joint-stock enterprises to be able to transfer equity more easily.
A VC’s purchase of equity in a business is similar to the purchase of shares in a listed business, except that there are a few differences:
The openness of information: VCs mostly invest in private companies (Private). Therefore, share prices and investment volumes for these investments are not required to be disclosed to the public as is the case when buying shares of companies on the stock exchange. However, some VC investments are now being announced like: “Company A gets an investment of $700,000 from Fund X at a 7-figure valuation”. This activity has the purpose of communication rather than the transparency of investment information.
Liquidity: Unlike shares on a stock exchange, equity in a private enterprise is not highly liquid. This means that VCs cannot easily sell this capital for cash or more liquid assets. In contrast, when buying a stock on the HOSE, for example, you will be able to liquidate faster by selling that stock almost anytime right on the floor at a published price.
To liquidate this investment, VCs will have to take an additional period of time, usually 3 to 7 years, and the price must be negotiated. Most startups are even more liquid than real estate. VCs, based on expertise, problem-solving skills and market sensitivity as well as a little luck, will get liquidity from this investment through the sale of their shares to mutual funds. other private investors, other companies or, in rare cases, go public through an initial public offering (IPO).
Active role: Unlike stock investment, investors who choose startups as an investment object will have to take a more active role. Often, they will have to use their knowledge, experience, and connections to help startups succeed. A VC will typically invest a 20-40% stake in a startup to ensure they have a seat on the board and have a say in strategic decisions.
Creation of new preferred shares: In the case of stock trading on the exchange, no new shares are created. Conversely, when a VC invests in a startup, a new amount of preferred stock is created in exchange for the cash the VC transfers to the startup’s bank account through shareholder equity. The increase in the number of shares causes the ownership of the business of the founders and previous investors to be diluted.
In addition, these newly created shares are often preferred shares. This means that VC shares will be preferred over common shares in a number of ways, such as divestment priority, voting preference, undiluted priority in the next funding round, priority. be eligible to participate in the following round of funding or dividend incentives. These rights will be discussed by the parties and we will analyze in detail in the next series of Term Sheet articles.
In Asia and especially Southeast Asia, VCs often ask startups to set up new companies to receive investment capital. Newly established company locations will be countries with open and professional financial services systems, strict investment legislation or easy cash flow. The locations that are usually chosen are the area where the fund is located, Singapore, Hong Kong or the tax havens of Virgin Islands, Cayman Islands, etc. This sometimes leads to some legal risks when raising money to come. The real market of startups. Therefore, startups and VCs need to discuss carefully, as well as balance the benefits when choosing the option of establishing a new company in another country to receive investment capital.
Equity and Debt: As discussed in the previous post, venture capital is a process that requires more than money with high risk, so the cost of equity investments is very high. expensive. When faced with the choice of borrowing or raising VND 2 billion for a startup, you will have to consider a few things:
If you borrow, you will have a personal debt (because a startup has no assets to mortgage). And if that startup fails, you’re sad twice, once for your startup and again for the upcoming time you have to plow to pay off debt.
If you raise capital, you will (1) not have to pay debt to VC because this is an investment, jointly owning the business, and the same board. It’s not easy for you (2) to get out of a VC just by paying off their debt. If the startup thrives, the VC will benefit more than the bank gets from you. This is obvious because the risk of VC is much higher. VC will create (3) pressure to divest because they will only be able to get the most profit from divestment. VCs won’t stay in startups to enjoy annual dividends because that amount is too small compared to the risk they are taking and the return investors give them hope for.
Building rapport and understanding the VC is extremely important because it is clear that when a dispute arises, you cannot get out of the VC easily. A popular example is Benchmark Capital’s 2017 lawsuit in Delaware court accusing UBER CEO Travis Kalanick of fraud for personal gain, breach of contract, and breach of fiduciary duty. The case was dropped a year later under an internal agreement involving a deal to buy back a large portion of capital at a valuation of $48 billion (30% lower than the most recent valuation) by UBER and a group of investors. another investment, led by SoftBank.
However, with that said, VCs don’t just invest money. They are the launching pad for many successful startups thanks to their experience, knowledge, relationships and strategic vision.
A Startup needs to understand and analyze carefully before making a decision to borrow or call for VC capital. There is never the best source of capital, only which capital is suitable for which business at a particular stage.
In part 3, we will focus our discussion on the audience most interested in investment funds: Fast-growing startups.
Documentation of the case: https://www.courthousenews.com/wp-content/uploads/2017/08/Benchmark-Kalanick-COMPLAINT.pdf
The COVID-19 pandemic has posed many challenges to the business world, especially to Venture Capital (VC) investment, when the risk factor is now multiplied given the increasing uncertainty sentiments. However, as individuals and businesses are trying to recover and respond to changes, along with challenges there are opportunities arising. This applies well to the Fintech industry, where businesses and financial institutions are collaborating to facilitate seamless digital finance for customers and corporations. Digital financing is no longer an additional fancy service package, but an essential when everything is expected to operate online.
According to a Fintech investment report by KPMG International, the first half of 2021 has seen a strong rebound in Fintech investment, with respect to both deal value and deal amount. The momentum is expected to carry on to the second half of the year, with focus spanning wide to different segments of Fintech, including
B2B services (banking services, not only in the payment sector but also in insurance, wealth management, regulatory, etc.)
So how has Fintech been riding the COVID-19 wave?
A study from Deloitte, “Beyond COVID-19: New opportunities for fintech companies”, has identified several advantages that the industry can leverage during times of the pandemic.
Expertise in data processing – a skill underlying credit and line insurance
Strong focus on digital customer experience
Leverage of partnership and collaboration – digital service providers are accustomed to shaking hands with large financial institutions (e.g. banks, funds, etc.) to complete the service chain
Unburdened by the complex, disparate, legacy systems – allowing them to quickly integrate cloud-native approach and take advantage of API system.
In short, fintech’s differentiated capabilities, agility, and innovation are helping it not only to survive the pandemic but also to take the opportunities and create breakthrough disruptions. As the huge potential of Fintech has proved itself a lucrative investment, let’s dive into some insights from VCs – one of the main sources of funding behind this rising industry.
Inside from VCs – main sources of funding behind this rising industry
FinchCapital, a Fintech and AI focus fund, believed that the crisis accelerates a “fundamental shift” in the lives of people and businesses, and this is where disruptive Fintech companies step in to help society respond to changes. While severe impacts are being seen across all industries, FinchCapital believes in the light at the end of the tunnel for these innovations, especially in the field Insurtech, Proptech, and Online mortgage, because post-Covid, a contact-free, data-driven, and insurance-protected lifestyle is the new normal.
In a webinar on Fintech investment (2021), representatives from DoVentures and Touchstone Partners – two significant players in Vietnamese VCs, expressed positive views on the future of Fintech, especially in Wealth management and online loan/mortgage/ BNPL (Buy now pay later) sectors. The movement is also supported by the State Bank of Vietnam (SBV)’s process of drafting a new decree on Fintech regulations, which will clear some of the grey areas and benefit fintech businesses, especially P2P lending largely. It was also emphasized that for such a sophisticated industry like fintech, the investors are looking for startups whose teams comprise both financial and technology experts. While the combination is clear in the industry’s name, such well-rounded expertise is not easy to find. Ideas that involve both integrations of new technology and response to financial system issues are more success-guaranteed.
Manuel Silva Martinez, Partner from Santander InnoVentures (SIV), also shared his interesting views on fintech investment after researching the industry’s global movement. Whilst being an advocate for “classic fintech” (mentioning “B2B blockchain application in the capital market”), the fund is also eyeing more forward-looking segments of fintech that directly drive customer decision makings. Similar to the aforementioned fund partners, Manual also named Proptech (mortgage cycle), Mobility (Car ownership), Logistic (trade and supply chain finance) being some of the potentials to pay attention to in the coming years.
In general, the pandemic has placed all businesses under distress, and fintech is no exception. However, with its high adaptability and data manipulation expertise, fintech is acing the crisis, through providing businesses and end-customers with innovative solutions that come as saviors during difficult times. Given the increasing trend of fintech investment, we expect the industry to thrive even further and create disruptive changes to our societies when COVID is behind.
To learn more about insight into fintech investment from VC’s point of view, why don’t you take a chance to join our upcoming event called Etalk Adventure to the Venture on Thursday night 23.09.2021 at 07:00 PM (VNT)
On 28 August 2021, 3 pm-4.30 pm (VNT), the Etalk – Adventure to the Venture: Special Chapter – Dermot Berkery with the theme Venture Capital in the emerging world was held by Wiziin Inc. via Zoom. The webinar was open to entrepreneurs, experts in the venture capital industry, or anyone else who is interested to learn more about venture capital. 80 people from many countries including Vietnam, Ireland, Singapore, Canada… were in attendance.
Host Tien Nguyen is the co-founder and CEO of Wiziin Inc., an AI-Based Investment Platform helping small and medium enterprises to get better and cheaper fundraising support while creating more value for venture investors. As a former Government of Ireland Fellow, Tien Nguyen has numerous entrepreneurial experiences throughout Ireland, Germany, and China.
Guest Speaker – Dermot Berkery is a General Partner at Delta Partners, a leading European venture capital company that invests in Ireland and the United Kingdom, for 22 years. Dermot has made 163 investments and 66 exits and has 32 companies in his current portfolio. Dermot wrote the book Raising Venture Capital for the Serious Entrepreneur, which is used as a textbook on VC in MBA programs around the world and in the Top 10 Best Venture Capital Book of All Time.
Tien kick-started the webinar by sharing his view on Ireland & Vietnam Entrepreneurship ecosystem and the bilateral relationship between the two countries. According to Tien, Ireland is a well-established entrepreneurial market with an active network of professional angels and syndicates, low taxes for businesses, multiple acceleration programs, and a strong and growing network of local seed funds and venture capitalists. Ireland has been investing heavily in Fintech, Biotech, Pharmaceutical, and currently renewable energy. Meanwhile, Tien opines that Vietnam is a nascent entrepreneurship market with a young and big population, stable political scene, high urbanization and technology adoption rate, good internet infrastructure, and numerous technology talents. However, Vietnam still has multiple challenges for VCs including lack of Government support, regulations and standards for VCs are not yet established, and foundational sciences are still developing. The market is very young and properties are not well protected, making investors hesitate to make investments due to high risks. As Ireland aims to build long-term and strategic relationships with Asiapacific for bilateral development, Tien opines that Vietnam can also learn a lot from Ireland to grow its VC ecosystem.
Following this, Dermot shared his experience of investments with Delta Partners. Delta Partners has invested in 120 companies in the IT, internet and digital sector during seed and early-stage (Series A) with a draw ranges from $300k-$800k and $2m-$3m, respectively. A typical growth path for a startup lasts 5-9 years, going through 5 stages as illustrated in the diagram below.
Delta Partners leverages its network and experience to help entrepreneurs to grow their small businesses in the first five years and then sell them to US big companies in the next five years. Dermot shared that Delta Partners does not do theme investments but invests in any business that works. Dermot stressed that it is important for entrepreneurs to hit the milestones set for each stage, as it would increase the valuation of the company and convince investors to continue pouring money in to grow the company.
Dermot stated the rule of thumb for $100mil is that each investment must have the chance of returning 10 times the investment, or 20% of the total fund, which is approximate $20mil. Some people might think the 10-time return from an investment is crazy, but Dermot opines that unless a business has such potential, investors will not invest in it in the first place. The below chart shows the investments and returns made by Delta Partners, where some investments lost all the money, but a few made more than 80% of the fund and that saved all the rest.
Dermot clearly highlighted the interesting philosophy of venture capital is to make small bets to win big money. “It is not so terrible for venture capital to lose money, but it is terrible not to win big when it does win.”, he said.
Dermot then moved on to answer the queries posted by the host and the participants. Below are the 5 most interesting Q&A of the session:-
Could you share your experience of raising money from Partners and how do you feel about it from a VC point of view?
For those who don’t know yet, VCs don’t just do investments but they have to fundraise from Partners, typically Government or high net worth individuals.
It might be hard for entrepreneurs to fundraise as capital is scarce, but it is even harder for VC as the investors have to invest for 10 years.
It is advisable to start your VC career with one that already has good track record and credibility so that the investors are more confident to invest.
Investors usually do not want to be the first to invest, they follow other investors. Government or the bank can be the cornerstone of the investment.
Should entrepreneurs in countries such as Ireland and Vietnam copy business models from fast-growing companies in the United States?
Dermot advised that a thorough analysis should be carried out to determine which business and market to go for. For example, Ireland with a population of only 5 million people is too small a market to develop a business like Google for Ireland.
In general, VCs look for innovative businesses instead of just copycats.
What do you do in a day?
Half of the time we help the companies in our portfolio to grow their businesses, acting as their adviser.
The rest of the time, we hunt for good business. We seriously HUNT, taking the initiative instead of waiting for entrepreneurs to find us. If you have a good business idea, we want to find you first before you come to others for investments.
What do investors look for from entrepreneurs?
VCs make up their minds very quickly, and they can decide whether a business can work within 10 minutes in the presentation. VCs will lose their interest if entrepreneurs cannot summarize their businesses in 1-2 slides. The entrepreneurs have to be able to show their thorough understanding of the industry they are going in, and issues that they are trying to solve, and how their products can solve the issues.
Dermot opines that ideally there are 2 to 3 founders for a business, and all founders should speak up in the presentation instead of only 1 person doing all the talking.
VCs do not necessarily know exactly how technologies work as these could be easily examined by third parties, but VCs expect entrepreneurs to pitch their business ideas clearly in plain English so even a person with no technology background can understand.
Do you keep in contact with the companies who lost?
Of course! These entrepreneurs spent many years developing their products and they learned valuable lessons from their failures. Hence, they are very good resources for the next projects!
This online sharing event with Dermot Berkery has closed the webinar series of six chapters Etalk: Adventure to the Venture by Wiziin Inc. We hope that the speakers’ sharing and insights have benefited greatly to all who are interested in the venture capital industry.
Want to join our very next exciting event? Subscribe to our event list now:
Venture capital is one of the options for early-stage companies and startups raising capital. To attract the fund, the company needs to prepare an excellent business plan. Before doing that, it is better to understand what a venture capital expects for new investment.
An attractive business plan will prove the following “The team and assets to be committed to the business can plausibly sustainable market power in a market large enough to justify the investment.” according to Dermot Berkery, author of Raising venture capital for the serious entrepreneur.
Market power is a key ingredient missing in most business plans. Hence, Dermot Berkery addresses three main propositions to examine if the business is worthy of investment from the view of venture capitalists.
Potential for accelerated growth in a big, accessible market
Venture capital investors will generally invest in a company only where they can see a way to earning a 10 or higher multiple on the investment. Thus, VCs focus heavily on the size of the market. They want to be involved in a big market that the company can grow quickly to a large size. But they are just like one that is not well signaled to investment communities. The reason is the weight of capital pursuing opportunities through different investment vehicles might drown the prospects of achieving great return on capital.
Ideally, they want to get involved in markets that rights on the cusp of takeoff that customers are yet willing to consider the product and there are no established competitors with good revenues. The business plan needs to outline how the early sales will be closed and how the sales model will scale over time, as well. They will assess whether the company will dominate in the industry, ranked 1 or 2. The dominance assures the ability to gain supernormal return as above mention.
Achievable position of market power
The business must meet three requirements: convey huge value to customers relative to offerings of competitors; have a sustainable, defensible position; yield very high gross margins (at least 70%).
Capable, ambitious, trustworthy management
Quality of management execution has a significant impact on the success of a company. Venture capital fund tends to look for a superb team that owns good characteristics including a balanced team, deep domain knowledge, prior experiences and record, and ambition.
The team needs to be balanced with a mix of technical, sales, marketing, skills, etc. Investors don’t want to back an individual, they want to back a team. The team needs to possess knowledge and insight not only macro-level trends but also micro-level facts. The company has more opportunities to convince VCs if members own great highly relevant resumes. More importantly, VCs want to cooperate with trustworthy and passionate management, who adapt to changing the business environment.
Ngành Đầu Tư Mạo Hiểm là một ngành thú vị. Những nhân viên tại các VC mà tôi đã từng làm việc, tư vấn và hỗ trợ đều cho thấy một sự thoả mãn cao trong công việc của họ. Tiếp xúc nhiều với những công nghệ mới, những nhà sáng lập thú vị và thông minh cũng như mức thu nhập hấp dẫn khi đạt thành tích khiến cho việc làm tại các VC đem lại nhiều trải nghiệm đặc biệt. Tuy nhiên, đây là một ngành cực kỳ kén nhân lực và hầu như có rất ít những chương trình đào tạo thực sự có thể đáp ứng đủ nhu cầu khắc khe của ngành. Chúng ta sẽ cùng tìm hiểu bộ máy vận hành của đa số các VC hiện nay và cuối bài tôi sẽ có một số lời khuyên cho những bạn trẻ đang muốn gia nhập vào ngành trong tương lai.
Các công ty quản lý quỹ mạo hiểm (VC firm) duy trì những đội ngũ tinh gọn. Ngành VC đòi hỏi sự ứng biến nhanh, thông tin trao đổi liên tục và tập trung cao độ. Do đó, chúng tôi không có quá nhiều phòng ban và các cấp nhằm việc ra quyết định được nhanh hơn. Cơ hội đầu tư luôn đến rồi đi rất nhanh, đặc biệt là trong các môi trường có tính cạnh tranh cao và số lượng lớn các VC cùng hoạt động.
VC firm hoạt động theo mô hình Partnership, khá giống các công ty luật, với 3 loại công việc toàn thời gian cơ bản:
Đây là những người ra quyết định cho các hoạt động chính của VC firm.General Partner (GP) sẽ góp một ít (một ít thôi!) vào quỹ mà VC quản lý. Họ được trả lương từ 2% management fee mà tôi đã đề cập trong các bài trước và 20% carried interest dựa trên tài sản tăng thêm sau vòng đời của quỹ. Tỉ lệ chia giữa các GP tuỳ theo thoải thuận nội bộ. GP sẽ chịu trách nhiệm chính cho việc gọi vốn về cho VC firm quản lý, ra quyết định đầu tư cùng hội đồng, hỗ trợ các công ty trong danh mục và lên chiến lược Exit. Tất cả hướng tới một mục tiêu là (1) Exit thành công,(2) hoàn trả vốn và (3) gấp 3 tài sản (triple the fund). Đây là những mục tiêu mẫu mực trong ngành.Limited Partner (LP) là những đối tác góp vốn như quỹ lương hưu, quỹ hiến tặng,…Các LP chỉ góp tiền theo các deal và ngồi đợi tiền về. Không can thiệp vào hoặc động hàng ngày của VC firm.Một VC firm dạng vừa sẽ có khoảng 4-5 partners. Mỗi partner có thể quản lý thêm 1 công ty trong danh mục sau mỗi năm. Số lượng này càng ngày càng tăng với xu hướng số vốn nhỏ hơn cho nhiều công ty hơn.
2. Non-Partner VCs:
Bao gồm Principals, Analysts và Associates. Trình độ cao hơn sẽ thêm Senior ở trước chức danh. Đây là các vị trí sẽ phụ trách các công việc như Sourcing, Initial Screening, Due Diligence, chuẩn bị các Term Sheet, Investment Contracts,… và là đầu mối đại diện làm việc với các startups và các cộng đồng. Về cơ bản, việc của nhóm này là phục vụ các đối tượng liên quan đến danh mục đầu tư của VC.Theo quan sát cá nhân của tôi, rất hiếm có trường hợp Non-Partner VCs được thăng cấp lên làm Partners trong cùng một VC Firm. Họ có xu hướng lập Firm mới để làm Partner hoặc nhảy vào một startup riêng của mình.
3. Administrative Support Staff:
Đây là những nhân viên sẽ hỗ trợ các công việc không liên quan nhiều đến hoạt động chính của VC như lễ tân, nhân sự, kế toán,…Xu hướng hiện nay đối với các VC là duy trì bộ máy nhỏ gọn để tập trung nhiều hơn vào các công ty trong danh mục đầu tư và tăng phúc lợi nhằm thu hút nhân tài (hiện đang rất hiếm trong ngành). Riêng tại Việt Nam, khi ngành VC còn rất mới và không có những chương trình đào tạo chuyên sâu, nhân lực cho ngành chủ yếu từ các ngành tài chính như Investment Banking. Điều này đang khá gượng ép vì khả năng chấp nhận rủi ro của VC và các ngành tài chính truyền thống khác nhau một trời một vực. Bản phân tích rủi ro mà chúng tôi chấp nhận có thể làm cho nhiều chuyên viên tài chính đau tim khi cầm lên đọc.
Đối với các bạn trẻ muốn tìm kiếm cơ hội trong ngành VC, tôi có 3 lời khuyên, cũng chính là 3 con đường mà các bạn có thể chọn.
1. Tham gia vào một startup tiềm năng. Suy xét kỹ càng và chọn cho mình một startup có năng lực. Cố gắng tạo ra khác biệt trong startup đó. Đảm nhận một vị trí quản lý then chốt. Tìm cách gặp gỡ các nhà đầu tư của Startup đó. Tìm hiểu về VC của họ và ngay thời điểm đó, lại tự đặt ra câu hỏi “VC có hợp với mình không?”. Nếu câu trả lời là Có thì bạn cùng đã có mối quan hệ rồi.
2. Tham gia thực tập tại các VC. Khối lượng công việc của các VC rất nhiều. Do đó, họ cần truyền tải cho các vị trí không toàn thời gian như intern. Các VC tại châu Á còn khá mới. Do đó, trong giai đoạn này họ còn khá dễ dàng trong việc chấp nhận một số vị trí intern mà không quá khắc khe như Âu Châu và Mỹ.
3. Làm việc trong một ngành khoa học đột phá. VC đam mê các lĩnh vực mang tính disruptive như tôi đã nói trong các bài trước. Các bạn trẻ tập trung vào các ngành như khoa học máy tính, công nghệ sinh học, năng lượng tái tạo hay vật liệu mới,… có khả năng rất cao được các VC để ý. Dĩ nhiên, bạn phải đam mê và hướng đến những nơi có các hoạt động đổi mới sáng tạo đột phá trong lĩnh vực của mình.
Ngoài ra, VC đòi hỏi sự am hiểu sâu về chiến lược, tài chính và các ngành đang tăng trưởng cao. Khả năng đọc, hiểu, phân tích và giải quyết vấn đề cực kỳ quan trọng. Chiến lược, theo tôi, là điều quan trọng nhất của một VC. Do đó, luôn tìm hiểu và để từ khoá này trong đầu nếu muốn đạt tới và thành công trên con đường VC.
Example: Organizational chart of one of the most successful VC in China, GGV.
The boom that tech startups have been experiencing has continued through the pandemic. Two leading venture capitalists talk about how investing in them is changing.
In recent years, startups and venture capital have experienced a boom many say can only be matched by the original dotcom boom of the late ‘90s. But this amount of success has raised all sorts of questions about the future sustainability of these times, particularly in whatever amounts to the next normal in a post-COVID world.
What are the most important changes or developments?
The most obvious one is what’s happened in the last 12 months with COVID, and the way that it’s accelerated the future that Silicon Valley has been building. We’ve seen many companies sort of achieve in 2020 what we thought they might achieve in 2025 as the future got pulled forward.
The specific things I’m excited about are that the grip of big tech on consumer-facing companies seems to be slipping, either because of regulatory scrutiny, or because they themselves are going to moderate their behavior. And then COVID itself has led to a whole raft of opportunities for companies to deliver services to consumers in a very differentiated way.
Startups can just move so much faster, so much more nimbly than the big incumbents. And then the other big trend is cloud computing and the associated explosion of machine learning, because of the abundance of data.
What is the biggest changes and developments?
Over the past year, practically all the startups we look at that address one of the legacy markets that is typically dominated by the financial industry, or retail, for instance, are outperforming the legacy incumbents on pretty much all parts of the business.
The cost of capital is lower for them, they have more access to talent, and they typically have lower customer acquisition costs. Also, their operating costs and their operating structure are far more efficient and effective to solve the needs of the modern consumer. So, unlike any time in the past 25 year, today I see that the future belongs to the startup ecosystem. And they’re scaling at a pace that I’ve never seen before.
There is opportunity for consumer- focused startups to compete more effectively but startups faring well not just against industry incumbents but also tech incumbents?
I think one of the differences is that Silicon Valley is at the forefront of developing new technology, new businesses, and new business models. Whereas, I think many of the very successful entrepreneurs coming out of the European ecosystem are addressing existing markets with disruptive technology solutions that in many cases have been proven in other settings.
So it’s a different version of innovation, I would say. Big tech obviously has a tremendous impact on, for instance, cost of customer acquisition if you’re a consumer company. It has a tremendous impact on how you market. But I think that is only a small part of the market that these promising European companies are actually addressing.
Diligence and deal making in the Zoom age
In my mind, whenever you make a decision the goal is to make it with high conviction, a high conviction “No,” or a high conviction “Yes.” So the way we’ve tried to do that, given the compressed timelines, is to have more of a prepared mindset.
We did this by developing two dozen “landscapes” last year. These aren’t a Ph.D.
thesis. It’s a couple of pages of somebody’s thinking on a particular category that we then present to the rest of the partnership. And everybody’s attuned to an idea, such as what’s happening with the emerging data stack, what are the services in and around cloud data warehousing that may emerge?
That was one of the landscapes we developed. So when we meet a company, we already have a framework in which to position them. And that way we can make a much faster decision.
It doesn’t mean that we come up with the precise nuances of the right idea. That’s part of the brilliance that you look for in the founder. Then once you’re in process, I think the biggest challenge is the inability to go visit somebody, to walk around their office, to get a feel for their culture.
You have to substitute for that by being even more diligent with customer references, off balance sheet references. So if it’s an enterprise technology company, for instance, you have a network of CIOs to call to understand what they think about this company’s value proposition. And I’d say we’ve done a lot more with personal references than we may have in the past as a substitute for that in-person judgment.
What are you looking for in a startup these days? Are there things startups should be doing to win you over as an investor that are any different in the past, or is it still all about the fundamentals?
I think it’s pretty much the same. You can simplify the concepts here. We really like a team that has this capacity to recruit world-class skills, and to capture the hearts and the minds of the people that really matter in their industry. You can diligence that even remotely. But you sort of feel it immediately when you sit in a room and talk to someone who really knows their stuff.
The second thing for us is that the market is big enough that it can create a massive business over time.
And the third one is that we would like to see a fundamentally different shaded product, one that has the capacity to really stand out with just a modest amount of marketing. Those three very simplistic arguments held five years ago, and they still hold for me today.
Funding and fundamentals
Talk about a funding bubble. How do you see the massive amounts of capital in the industry impacting startup priorities and decision making?
I think there has been this very popular concept of “blitz scaling,” the idea of extremely fast decision making and building capabilities.
The flipside of that is there was a lot of sloppiness, such as poor company culture, that started to happen. And I think now we’re in a situation where we have even more money coming into the market, but also very strong KPIs have been produced thanks to the increase in digital usage and demand during the pandemic.
You can also see a lot of false positives in this environment that might not sustain for the long haul. So the challenge for us as investors, I think, is to see when you’re building something really quickly, with so much access to capital, that is quality can vary greatly between different opportunities.
It can be a little harder in this environment to know what is truly sustainable. Is that something you and your team have to think about a lot?
the business fundamentals are the same. The shape of it is different, just like the shape of businesses today are different from the ones we funded 20 years ago.
Because the market has changed, the opportunities have changed. The two questions I like to ask typically are, “Who cares,” and, “Why now?” And, “Who cares,” sounds a little whimsical, but the idea is, what is the problem you’re addressing, and why do you have a compelling solution?
It has to be compelling. You want to build a product or a service where your customers find you, and you don’t have to go find them. That’s when you build something truly distinctive. And then the next question obviously is, is it a sustainable advantage?
And “Why now” is just, what are the environmental reasons that make it propitious to start this company today? Because big companies have so many advantages. You need to have some kind of disruptive change.
In terms of sustainable advantage and durability, I think it’s something we wrestled with more in the second quarter last year, right after COVID struck. Because we had companies like DoorDash and Instacart who were benefiting tremendously in food delivery and grocery delivery.
And the question obviously is, does it sustain, or is this a blip? And conversely, we had companies like Airbnb and Eventbrite that obviously saw enormous decreases in revenue because of the curtailment of travel. I’d say, given that COVID has continued for 12 months, and we’re likely in for at least another six to 12 months, it actually creates an environment for behavior change to become more set.
And I think that is really interesting in terms of the opportunities we get. So, take tolerance for working over Zoom, for example. Maybe it’s something you endured for a few months, and you were looking forward to going back to the way things used to work. But now I think maybe you’ve gotten used to it, and you see the advantages. You also see the disadvantages, of course. But my guess is that Zoom is going to be a firmament in how people operate from now on. There are so many companies that have had to embrace inside sales instead of direct sales.
Because obviously, their salespeople couldn’t travel. And now they understand the benefits. There are services like Gong that help you record your phone calls with customers, that help with training the rest of the sales team. You can analyze what works, what doesn’t. Productivity has just been raised for everybody. And, so, I think a lot of these things are going to be much more durable than we may have imagined six months ago.
Judging the soaring valuations
When you look at the future, or even the present, do you feel that there’s enough economic value creation to justify the number of unicorns or decacorns?
There are some signs that the entire market is sort of on zero interest rate steroids. We have a situation where the valuations are high, there is no doubt about that. But then the question is, will they produce returns at the scale that we were hoping for?
And you know, for most of the startups that we have looked at over the past 25 years, very few of them actually get even close to their plans. Some of them do. And they become these unicorns or decacorns, or even more.
But I think this time it’s like a change of scenery for the digitally-powered, innovation-powered economy. I think many tech startups get more bang for their buck, they scale more, they create higher returns on their business models.
And since many of these business models are also going from sort of selling units to selling a subscription that’s like software-as- a-service (SaaS), for instance, that it’s also a totally different profile of earning. So I think there are certainly arguments for this being frothy, absolutely. But I think also that there are companies that are growing at the rate now that we haven’t seen before.
Startup fundraising pitfalls
When you look at so many startups and pitches constantly, what do you see as the most common mistakes or pitfalls as they try to raise capital?
Well, I would say one of the most common mistakes is that you haven’t really thought through how much you can achieve with the money that you’re thinking about raising.
So it becomes almost like a circular reference in the conversation, and then an unproductive discussion. What we would like to see more about is, okay, what is the big next big inflection point that you can reach? And how much capital do you need to get to that big inflection point –where you can get access to customers more easily, or you can scale at a different speed, or you can start to prove your business model?
And when that is not thought through, then it basically starts to sputter really early in the conversation. So when I get the question, “What do you need to hear in a pitch,” well, I want to see what can you achieve in a reasonable timeframe. And what is the kind of capital you need to do that, in order to sort of really be a different company at that point in time?
The first is substance versus form. You need to be authentic. You need to just tell your business story, and explain what it is you do, and try not to make it performance art.
The second one is choosing your business partner. I spoke about it earlier. Fundraising is a recruiting exercise for your future business partner. There are people like PJ or myself who have decades of experience, who can help you see around corners. I’m sure that between the two of us, we’ve made more mistakes than any of these founders hopefully will make.
And the goal is to learn from the mistakes we’ve made, which means you don’t have to repeat them. And so you’re recruiting a business partner. Don’t just take the highest valuation. Don’t just take the easiest money.
Find somebody whom you trust, who’s going to be at your side, somebody who you can call on a Sunday night when something blows up at the company, when you have a squabble with your cofounder, when your biggest business partner goes sour on you. Who are you going to turn to for advice to help you navigate those moments? That is what you’re looking for. And, so, take the fundraising exercise a lot more seriously as a recruiting exercise.
Source: McKinsey on Startups
Roelof Botha is a partner at Sequoia Capital and Pär-Jörgen (PJ) Parson is a general partner at Northzone. Daniel Eisenberg is a senior editor in McKinsey’s New York office.
Can an algorithm outperform the average angel investor? And if it can, does that also mean it will make less biased investments? Researchers put these questions to the test: They built an investing algorithm and put it head to head with 255 angel investors in a simulation, asking it to select the most promising investment opportunities among 623 deals from one of the largest European angel networks. The results? The algorithm significantly outperformed the average novice investor and even experienced investors who fell prey to cognitive biases, but was bested by the top tier of experienced investors, who could control for their own biases. While the algorithm may have made less biased choices when it came to the race and gender of the founders it picked, it also reflected systemic inequalities, and illustrated the limits of how algorithmic investing can be used to address deep social inequalities. Even so, the experiment offers a vision for how — and when — investors might deploy similar algorithmic aids in their investing, and how it might lead to better and fairer decisions.
Many large venture capital funds use artificial intelligence (AI) to support their investment decisions. Bill Maris, former managing partner at Google Ventures, once said that when you “have access to the world’s largest data sets … it would be foolish to just go out and make gut investments.”
Most startup investors, however, do not have access to Google-esque resources and still do things the old-fashioned way. Angel investors, for instance, rely heavily on gut feeling to make investments. But as technology advances and the cost of building powerful algorithms through machine learning decreases, these investors will need to decide whether to incorporate AI. Can it outperform human judgment in making early stage investment decisions? And how should angel investors use it?
To answer these questions, we built an investment algorithm and compared its performance with the returns of 255 angel investors. Utilizing state-of-the-art machine learning techniques, we trained the algorithm to select the most promising investment opportunities among 623 deals from one of the largest European angel networks. The algorithm’s decisions were based on the same data that was available to the angel investors at the time, which included pitch material, social media profiles, websites, and so on. We used this data to predict a startup’s survival prospects — instead of measures such as valuation, which investors often favor — because it allowed us to train the algorithm with a much larger and more reliable dataset.
For our test, we used this prediction model to simulate investments and to compare the returns of the angel investors’ portfolios against the ones that were created by the algorithm. We further investigated how angel investors of varying experience — novices with fewer than 10 investments vs. expert investors with at least 10 investments — faired relative to the algorithm’s performance. Expert angel investors in our sample, on average, made about twice as many investments as novices (12.2 vs. 5.2) and invested double the amount per startup (€10,530 vs. €4,548).
The results were striking, and offer significant insight into how — and when — algorithmic investing tools might be used to maximum advantage. According to our research, novice investors are easily outperformed by the algorithm — with their limited investment experience, they showed much higher signs of cognitive biases in their decision making. Experienced investors, however, faired far better. As such, our research shows how biases shape the decisions of human investors — and how working with algorithms might help produce better and fairer investment returns.
The Algorithm vs. the Angels
It has been well documented that cognitive biases — meaning systematic deviations from rational behavior — lead to inferior investment performance. We measured five biases: 1) local bias, which describes angel investors’ tendency to make investments that are in close geographic proximity to themselves; 2) loss aversion, meaning angel investors’ tendency to be more sensitive to potential losses than to potential gains; 3) overconfidence, when investors “overcommitted” and spent significantly more money on one startup that they usually would; 4) gender bias; and 5) racial bias. Our data shows that all biases were present among the angel investors with overconfidence — which 91% fell prey to at least once — being the most frequent and strongest bias to affect investment returns.
Because cognitive biases cause investors to make irrational investment decisions, it is not surprising that our investment algorithm outperformed the human average. While the algorithm achieved an average internal rate of return (IRR) of 7.26%, the 255 angel investors — on average — yielded IRRs of 2.56%. Put another way, the algorithm produced an increase of more than 184% over the human average.
Not all investors are equally susceptible to their biases, however. For instance, angel investors with lower signs of irrational behavior in their portfolios performed significantly better than their rather irrational counterparts: the less biased novice group averaged 3.51%, whereas the novice group with higher biases, on average, lost money at -20.52% IRR.
Intrigued by these results, we investigated whether the algorithm would win even when the investors were highly experienced. What we found is that experienced angel investors showed far fewer signs of cognitive biases and therefore achieved significantly better investment returns. This elite group of experienced angel investors achieved an average IRR of 22.75%. Experience alone, however, does not do the trick: Investors who had a good deal of experience but also showed high levels of cognitive biases achieved, on average, only 2.87% IRR. Our results thus show that only experienced investors who can suppress their cognitive biases effectively outperform machine learning algorithms in making early stage investment decisions.
There was one other factor we found to be at play, which may give algorithms an edge. Achieving higher portfolio returns in venture investing has two sides – protecting the downside and increasing the upside. A central thesis and the main focus of venture investing has always been to find statistical outliers (i.e., “unicorns”); our study, however, gives reason to rethink this central investment hypothesis in angel investing. By predicting survival probabilities, the algorithm was able to pick much better portfolios than the large majority of the 255 angel investors. As such, our data suggests that in the greater scheme of things, it might actually be more important to avoid a bad investment than to try to hit a home run. Given their limited funds, angels only invest in a finite amount of ventures and must, therefore, take great care with each investment. Therefore, asking “is this a viable business with very high chances of survival?” might be more valuable in achieving higher portfolio returns than searching for the needle in the haystack.
Does Better Also Mean Fairer?
There has been ample discussion about whether algorithms are biased by their creators. In our case, the outcomes in the training data were not classified by humans directly (compared, say, to hiring algorithms, where humans decide who has been a good hire in the past). The algorithm was trained on actual survival and performance data of hundreds of ventures. Given this high degree of objectivity, we see that compared to the average investor, the algorithm’s portfolio selection was less influenced by classical investment biases such as loss aversion or overconfidence. That doesn’t mean it didn’t show bias, however. We were surprised to see that the algorithm did tend towards picking white entrepreneurs rather than entrepreneurs of color and preferred investing in startups with male founders.
Given these specific results, we can say that the current controversial discussion around biased algorithms that are being blamed for making unfair decisions is overly simplistic and misses the underlying problem of inflated expectations. Machine learning models are frequently trained to discriminate between different decision alternatives, e.g., good or bad early stage investments. AI itself is, per default, not irrational or biased; it just extrapolates patterns that exist in the real world data that we give it to learn and to exploit these patterns in order to distinguish between the potential decision alternatives.
Thus, AI may be able to counter the flawed decision-making processes of individual investors with low investment experience, e.g., it may help correct investors that overestimate their ability to assess the risk of a given investment. However, using AI as a means for fighting societal inequalities is more challenging. Although all data sources were objective and free of human judgement in our case — and the algorithm was not fed race and gender data — it still came to biased decisions. But the algorithm itself did not make biased decisions; it reproduced societal inequalities that were inherent in our training data. For example, one of the most important factors on which the algorithm based its predictions was prior funding that the startup had received. Recent research shows that women are disadvantaged in the funding process and ultimately raise less venture capital which may lead to their startups not being as successful. In other words, the societal mechanisms that make ventures of female and non-white founders die at an earlier stage are just projected by the AI into a vicious cycle of future discrimination.
Importantly, our results indicate that consciously debiasing decisions for race and gender might increase not only fairness, but also performance of early stage investment decisions. For instance, we found that experienced investors that invest in ventures of non-white founders systematically outperformed our algorithm. Thus, these experienced investors made successful investment decisions that were free of the implicit patterns of discrimination that undermined the results of our algorithm. In general, there is always a tradeoff between fairness and efficiency in resource allocation. This tradeoff is also apparent in algorithmic decision making. We can never expect AI to have a built-in solution to automatically solve societal problems that are inherent in the data that we feed it.
A Hybrid Approach
Our research underscores the advantages of using AI in early stage investing. It can process large amounts of data, correct individual investment biases, and, on average, outperform its human counterpart. At the same time, the most successful individuals — experienced investors able to correct for their cognitive biases — outperform the algorithm in terms of both efficiency and fairness.
Of course, this doesn’t have to be a binary choice between gut feeling and algorithmic decisions. Managers and investors should consider that algorithms produce predictions about potential future outcomes rather than decisions. Depending on how predictions are intended to be used, they are based on human judgement that may (or may not) result in improved decision making and action. In complex and uncertain decision environments, the central question is, thus, not whether human decision making should be replaced, but rather how it should be augmented by combining the strengths of human and artificial intelligence — an idea that has been referred to as hybrid intelligence.
Artificial intelligence in the loop. Our research shows that algorithms could help novice investors in making early-stage investment decisions. To start angel investing with the help of an algorithm enables novice investors to avoid decision caveats and thus to achieve higher returns early in their investment career, which encourages them to continue investing. Angels who keep investing provide important resources to an ecosystem that fosters job creation and innovation. Therefore, we see lots of potential in investmentalgorithms to train novice investors in making expert-like decisions that result in improved financial returns.
Human intelligence in the loop. For more experienced angel investors who have learned to manage their cognitive biases, our findings show that their intuition should still be considered the gold standard of early-stage investing. So, algorithms should not only be trained on “objective” past performance data that easily reproduce societal biases, but also on the decisions and actions of these selected decision makers. Therefore, at same time, we see potential in experienced investors to train investment algorithms to make better and fairer investment decisions.
In the end, despite AI is rapidly entering the financial markets, best-in-class early-stage investments are still dominated by experienced angel investors. The key to building an investment algorithm that can ultimately replace even the most experienced angel investors in making their investment decisions does not only lie in counteracting human biases but also in mimicking experts’ intuition in finding the most promising investment opportunities.
From medicine to retail to the auto industry, there are few industries in tech that have not been changed or disrupted by artificial intelligence.
Now, some of the people investing in those sectors are using AI to figure out where to put their money next. While that may seem like an obvious use of AI and machine learning, it’s been something most VCs have been slow to adopt.
“VCs love to disrupt other spaces using data and networks—except their own,” said Ilya Kirnos, co-founder, managing director and CTO of San Francisco-based venture firm SignalFire.
Investment firms such as SignalFire and EQT Ventures are not just investing in tech companies, but are in their own way tech companies—housing their own proprietary AI platforms to analyze and vet investment opportunities.
AI directs big money
Alastair Mitchell, partner at EQT Ventures, estimates the firm’s AI platform–called Motherbrain–for sourcing portfolio companies has played a role in about $200 million of the firm’s approximately $900 million total invested since its first fund opened in 2016.
“We placed a big bet on technology to be better investors,” he said.
Motherbrain digests both public data, such as investor and LinkedIn data, app store rankings and funding information, as well as proprietary information to score companies. Mitchell estimates the platform is helping the firm track about 2 million companies.
Stockholm-based EQT Ventures, which describes itself as a hybrid between a startup and a VC firm, plans to use Motherbrain over the next few years to help it find investment opportunities for its second fund, which launched last year. About 75 percent of that $700 million fund is still available for investment, said Mitchell, adding that three of the firm’s top five investments from its 2016 fund were sourced through Motherbrain.
The firm, with investments that include Wolt, Handshake and Netlify, also recently promoted Henrik Landgren, who specifically oversees Motherbrain and previously built Spotify’s global analytics team, to partner.
While EQT Ventures is a separate set of funds from the private-equity firm EQT, Mitchell said the more traditional investment firm also has used Motherbrain to analyse growth fund opportunities; illustrating that the use of AI is moving beyond just venture.
AI not just to invest
However, AI uses for firms stretch beyond just investing. SignalFire looks at four stages of successful investing: sourcing, diligence, placing the investment, and adding value to that company once it is in the portfolio, Kirnos said.
SignalFire, which usually invests in seed or early-growth rounds, uses its AI platform in all four phases.
“It has differentiated us,” said Kirnos, who was a software engineer at Google before co-founding SignalFire.
While SignalFire uses AI to help source and do its diligence before investing in companies, the company also uses its proprietary platform to help its portfolio companies grow by analyzing and researching their markets, recruiting talent and creating business strategies. The firm uses its platform to track more than 2 million data sources and half a trillion data to help tell a company everything from how to differentiate itself to how to price its product.
Kirnos said he also looks at his firm as a tech startup, one that has used AI to now invest in nearly 100 companies, including the likes of Grammarly and Ro, formerly Roman Health.
“We have companies in our portfolio that could be public companies,” he said.
COVID and the digital transformation of investing
Nearly every tech executive and investor talks of how the COVID-19 pandemic has caused a “digital transformation” in all sectors and areas of work.
That may apply to investing too, Kirnos said.
“Companies are remote now with COVID,” he said “The stuff you track is more widely dispersed.”
Kirnos said the days of hiring a graduate from Stanford University to go out to talk to people about the next big thing in tech are at least temporarily paused due to the pandemic.
“You have to use data, you have to use systems,” Kirnos said.
With SignalFire having about $1 billion under management and EQT Ventures investing from its second $700 million fund, other investors may eye the returns on that money to see if AI is something they should not just invest in, but also use.
“No doubt as we are successful, there will be imitation,” Kirnos said.