How do venture capitalists identify their “unicorns”?
The secret is out that startup investing is binary, with the majority of VC industry returns concentrated on a few winners. And while Angel investors have addressed this power law via diversification, top tier US VCs have been more proactive, trying to predict breakout successes early and betting big.
In other words, if we knew ahead of time which companies will be successful, the ultimate outcome for any fund would be to invest 100% of it’s capital in one mega unicorn in its very first round. This new modus operandi, termed “Fundraising Acceleration”, leads to the obvious question: is it possible for VCs to accurately identify upcoming winners in a way that avoids price wars?
Learning from hedge funds
In the crowded and efficient public markets, the only way to consistently profit over time from trading stocks is by getting an “edge” aka proprietary information. The recent New Yorker article titled “The Empire of Edge” provides some examples of the lengths hedge funds go to for an information edge, including:
…in order to evaluate a technology stock, hedge funds sent “people to China to sit in front of a factory and see whether it was doing one shift or two.”…At their disposal was a boutique firm full of former C.I.A. officers who could monitor the public statements of corporate executives and evaluate whether they were hiding something
Hedge funds are focused on finding growth in stocks that others don’t yet see, and with the increasing digitization of startup investing, VCs will need to consider how to give their investment teams a similar “edge”.
Similar to hedge funds, VCs will need access to tools that collect proprietary data and turn it into insights.
In terms of collecting the data, there has been a rise in software solutions aimed at making startup investing more efficient. Examples include cap table management, tracking of startup metrics, and generation of dynamic “one pagers”. These companies grow their data bases each time you use them, gathering proprietary startup data points around valuation, engagement, churn, and revenue that are impossible to gain at scale today.
For turning the data into insights, companies like Mattermark analyze publicly available signals such as employee count, online presence, and fundraising to generate startup momentum scores. These tools are gaining market share with investors trying to identify breakout startups online today, and in the future, they will be well positioned to purchase data from the above tools to further enrich their models, becoming “Bloomberg for startups”. In this case, tracking startup momentum scores will be table stakes, similar to owning a Bloomberg terminal when investing in public markets.
Edge for VCs
Unlike hedge funds that focus on public stocks where anyone has the right to invest for the market price, breakout startups can be selective as to whom they sell stock to. So while access to data networks will be important to identify upcoming winner, the true “edge” in the Fundraising Acceleration space will be gained by investing in people networks.
Two examples of this include Andreeson Horowitz’s talent management network and First Round Capital’s CEO Forum. These people networks power brand and relationships, enabling these VCs to interact with promising startups ahead of time in a meaningful way. When competing for breakout deals vs. other VCs that are contact startups after it’s already clear from the data network they’re achieving initial breakout momentum, this edge may make the difference.