On Funding — The Denominator Effect

Recently, I wrote a post on funding to encourage investors to consider having a diversified portfolio. I called it "shots on target" because it is almost impossible to predict which deals will be successful. You need to have at least 15-20% of the best deals in your portfolio. Perhaps if you had 30-40 deals funded, only one or two would bring in the most returns.

A shot on goal can be thought of as the numerator in fractions. The numerator refers to the deals you have completed, while the denominator refers to the number of deals you saw. Our funds do 12 deals per year and see many thousand. The funding rate ranges from 0.2-0.5% depending on what you consider "evaluating" a deal.

This is Venture Capital.

The Denominator Effect

Here are some consistent pieces of advice that I give new VCs and angel investors. Concentrate a lot upon the common denominator.

Let's say you are a well-connected person with a strong network of colleagues and friends in the technology sector. You also have many friends who invest professionally or individually.

There are good chances that you will find a lot of great deals. You might even find some deals that are truly amazing. It's easy to find executives who are leaving companies like Facebook, Google and Snap. Engineers can be found at Harvard, Stanford, Harvard and UCSD. Caltech executives will also be available. There are literally thousands of talented people in the world from top schools and top companies.

Add to that people who worked for McKinsey and BCG, Bain and Goldman Sachs and Morgan Stanley, and you will find not only young, ambitious talent, but also people who are great at creating presentation decks with data and charts, and have perfected narrative storytelling using data and forecasts.

Let's say you attend 10 meetings. I'm confident that at least three of these meetings will be interesting if you are smart, thoughtful, and able to hustle to get in front of great teams. How could you possibly not get in front great teams?

Let's say you are determined to see 100 deals in a 90-day period. You meet as many people as possible and try to get to know as many people as possible. After seeing 100 companies, I am confident you will have four or five that stand out and that you find compelling.

Here's the problem: almost certain there won't be any overlap between the first three deals that you considered high-quality and the four or five you now want to bang your fist on to say you should fund.

Okay, but this thought experiment must be extended. Let's suppose you had 1,000 companies for a year. It is unlikely that you would advocate funding 300-400000 of them (the same proportion as 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. The 7 or 8 deals you see would be very different from the 4 to 5 that you saw first and were willing to fight for.

Venture is a numbers game. Angel investing is no different. To be able to tell the difference between great deals and exceptional, you need to see many of them. You won't be able to fund deals that you find compelling in the moment.

My advice boils down into these points:

You should make sure that you are able to find many deals. To recognize what is truly extraordinary, you need to be able to recognize patterns.

Don't rush to do deals. You will almost certainly see a rise in the quality of your deal flow and your ability to identify the best deals.

Personally, I am a big fan of focus. It's difficult to spot the patterns and know what the truly extraordinary is. You can develop intuition and expertise if you meet every FinTech company possible (or even just one sub-sector like Insurance Tech).

To build a diverse portfolio, get lots of shots on the goal (completed deals), To maximize your chances of success, make sure you are shooting from a large number of deals (the numerator).