While venture capital funding has been slowly rising in the US over the last fifteen years, the year 2021 witnessed record highs. Companies supported by US venture capital funds raised almost double the previous year’s record, going from $166.6B in 2020 to $329.9B in 2021.
Amid this newfound funding frenzy, it is important to remember that venture capital is a high-risk, high-reward game in which the Pareto principle plays out: 80% of the returns stem from 20% of the deals.
Let’s look at some core strategies that help ensure a few home runs in your portfolio will make up for the remaining companies that weren’t so successful.
Strategy 1: Using a Thesis Driven Investment Framework
While it can be tempting to evaluate a wide range of deals across sectors and fund companies at all stages of growth, it may be more useful to redirect your firm’s energies towards an investment thesis you believe in that should underpin all startups in your portfolio. An investment thesis - a reason for your investment strategy and choices - based on comprehensive sector research and data-driven insights can become the north star for your portfolio. It helps you determine which of the startups you come across has the potential to align with your vision for change to drive transformative growth in the sector.
Union Square Ventures, a thesis-driven venture capital firm, has applied this strategy while making investments in blockbuster companies like Twitter, Etsy, Tumblr, Kickstarter, and Zynga. USV’s 2004 fund, which made early investments in Etsy and Twitter, has been one of the best-performing sub-$250M VC funds in recent history, posting a spectacular 13x DPI.
With your investment thesis in mind, you should also consider the following criteria while evaluating startups.
1. Opportunity Size
The scalability of a startup idea is perhaps the most important criterion to consider in your evaluation. For a venture to deliver the kind of sizable returns sought by venture capital, it has to be scalable. The startup must have the potential to capture a significant portion of its target market. In addition, the total addressable market must also be promising.
2. Founder Attributes
The founders should have a healthy mix of passion and vision as well as stellar execution ability. Each member of the founding team should be aligned with the short-term and long-term objectives of the company, and together, they must take on core roles essential for growth. In addition, investors are often drawn to founders who are open to constructive feedback.
3. Execution Strategy
As a venture capital investor, it is important to see the startup’s business plan in action before committing funding. Watching the startup’s execution strategy play out with real users of the product or service helps investors see demonstrated proof of concept and witness the company’s traction compared to competitors.
After you’ve identified an opportunity that meets these criteria and aligns with your investment thesis, your decision may finally come down to the startup’s valuation. As an investor, you may choose to invest or pass on a deal depending on your perception of whether the valuation asked for is reasonable or inflated.
Strategy 2: Nurture Your Startups During the Holding Period
Once you have made your investment decisions, you need to put in your best effort to help the startups in your portfolio succeed.
In the initial stages of growth, startups are bound to pivot their business models or modify execution strategies in response to the market. It is at these critical junctions that VCs can serve as a resource and a sounding board while ensuring that startups continue to grow and make progress toward their goals. VC firms can leverage their networks and share best practices drawn from experience to support portfolio companies as they navigate the roadblocks that often crop up in the startup journey.
For VCs to act as a catalyst and accelerators for the company’s growth, it is imperative that they closely track the company’s progress. With its modular design and customizable templates, the Zapflow platform is particularly useful in helping gather both qualitative and quantitative data from portfolio companies in one place, avoiding unnecessary back and forth email correspondence. It helps streamline workflows and makes portfolio monitoring a seamless process.
Take a look at Spotify’s story. They’ve had the backing and guidance of Swedish VC firm, Creandum since their first round of financing and through many ups and downs within Spotify’s structure and the global economy. Staffan Helgesson, a founding partner at Creandum, has often spoken about seeing Creandum seeing itself as a strategic thought partner that goes beyond just providing funding.
Strategy 3: Be Wise About Exits
A major success metric for a VC fund is Return on Investment (ROI), a measure of profitability that compares the return on the investment to the original cost of the investment. VC firms often invest in high-risk businesses, so timing a strategic and profitable exit may even be more difficult than a strategic entry. However, it is important to be wise about your exits because the returns a VC fund generates for its limited partners (LPs) will determine its success in raising subsequent funds.
Sequoia Capital’s investment in WhatsApp and the company’s subsequent sale to Facebook is one of the most well-known examples of a masterfully executed entry and exit by a VC firm. Sequoia managed to strike a mutually respectful relationship with WhatsApp’s founders, managing to be the only VC firm on WhatsApp’s cap table in both its Series A and Series B rounds. As a result, it enjoyed a spectacular exit when Facebook bought WhatsApp for $22B in 2014, turning its $60M total investment into a $3B return. The Facebook-WhatsApp deal was the largest private acquisition of a VC-funded company at that time.
There has never been a more exciting time to be a venture capital investor. Both 2020 and 2021 were record-breaking years for venture capital investment in the US, and this trend of surging deal volume will likely continue in 2022.
These three strategies we have outlined are stepping stones you can use to make your mark in the venture capital industry. As you begin your journey, we recommend using Zapflow to manage your pre and post-investment workflows. Book a demo to learn how you can use Zapflow as a productivity tool to optimize your data collection and increase the efficiency of your investment team.