Understanding Deal Flow
Over the past few months, I have talked to a number of venture capitalists. All have unique backgrounds, but very few have experience investing in the public markets. This got me thinking about the different challenges that VCs face compared to the public counterparts. The two biggest differences I have found are differences in deal flow and the meta game.
Soon, I will post more about the Meta Game that VCs and Public Market investors play!
But this week, I will talk about the challenges of deal flow , where venture capitalists can only get deal flow through their brand, luck, or tolerance for bad deals. These dynamics are very different from public market investors who are swamped with potential opportunities. Enjoy!
§Deal flow for Venture Capitalists
To get deal flow as a venture capitalist, you need to have a brand, be lucky, or accept below-average deals. Usually, all 3 are at work, but most VCs will get their deal flow predominately from one of those factors.
Nobody comes to me to invest in their start-up, because I have no brand! If you want to be successful as a VC, you need a top-tier reputation, either as an industry specialist (Lux Capital) or add tons of value (a16z). Entrepreneurs have one job as it pertains to their business: don’t die. Most entrepreneurs know enough to look for VCs that will reduce their odds of death. This means that the best VCs are able to decrease the chances of the business failing via their investment. Truth be told, these types of VCs are rare!
The other avenue for deal flow is to get lucky. As in, you somehow found the investment and entrepreneur by pure luck- you raised them, they overheard you talking at a restaurant, etc. This can lead to owning .5% of Microsoft, but it can also lead to many failed investments. Luck is often not repeatable , nor does it guarantee good deal flow. As my brother would say, you have to know a guy.
If you do not have a top-tier reputation or luck, then you will only get deals that the best VCs have passed on. As in, you are the entrepreneurs last resort. They only came to because much better investors already said “no”. This may give the VC an advantage when structuring the deal, but if the company fails, you will most likely lose money despite any creative deal making. Good luck building a great track record with this type of deal flow!
Even if you have a reputation, luck, and are willing to buy into rounds other investors pass on- there is no guarantee the company will want you as an investor! The company has full autonomy to reject your investment.
§Deal flow for public market investors
Public market investors, on the other hand, have too much deal flow. If you are managing less than $1B, then you can probably invest in ~10,000 different companies. Almost none of which can deny you an investment. This leads to boiling the ocean.
Nobody can look at 10,000 companies deeply, and public market investors need to make sure they do not overwhelm themselves. This can be done with filters, which let an investor know if they should continue digging (IE only invest in US-technology companies). VCs have a similar filter, but it is often used to say “no” to companies that are already in their “deal funnel”.
Unless start-ups are stumbling over themselves for a 20-minute meeting with you, venture capitalists will almost always have a worse deal flow than public market investors. I know which game I would rather play!