Lame LPs, founder referenceability, and the future of VC signaling
I’m still going through some of the comments I received on last week’s articles about the heightened competition among VCs for the best (typically SaaS) venture deals. Some more notes on whether large funds investing in small rounds causes VC signaling risk in a moment, but first, a fun anecdote about how lame LPs (still) are.
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I was catching up with an ambitious founder of a VC firm this weekend, and we were taking about fundraising for VC firms and particularly the process of connecting with limited partners. Like startup founders, investment firms typically submit fund proposal decks and data rooms to potential LPs, who are then supposed to evaluate said material and either move toward an investment, ask for more information, or run the hell away.
Unlike VCs, however, LPs have apparently not caught on to the fact that access to this information is much more trackable than it was in the past. VCs now realize that their perusal of a deck on DocSend is being monitored by founders, and I have heard from more than one VC over the years that they have their executive assistants click through a deck in a deliberately slow fashion to make it look like they are putting more thought and attention into reading a founder’s fundraise deck than they really are.
LPs though have no such inkling that this is going on apparently. From the VC firm founder this weekend (paraphrasing), “What’s amazing is that I get asked for my data room, and then the potential LP will setup a time two weeks in the future to meet again. Fifteen minutes before our meeting, I get an email notification that they finally opened up the data room and started accessing its files.”
The best part is where the potential LP then waxes on about how much thought they put into their feedback to the VC.
Founder referenceability
As I explained last week, the paradox of big VC funds today is that they are actually doing more of the smaller startup fundraises as a way to secure access to later-stage deals.
So for many deals today, those later-stage cap tables are essentially locking out new investors, because there is already so much capital sitting around the cap table just salivating to double down.
That gets us straight to the paradox. In order to have access to later-stage rounds, you have to already be on the cap table, which means that you have to do the smaller, earlier-stage rounds. Suddenly, growth investors are coming back to early-stage rounds (including seed) just to have optionality on access to these startups and their fundraises.
One response I heard from a seed VC is that they focus on “founder referenceability.” What they mean by that is they use their existing portfolio founders as the key persuasion tool to convince new founders to take their term sheet over other (larger) competitors.
This particular seed investor argued (whether true or not) that they spend copious amounts of time in a concentrated manner with their portfolio companies, helping them with recruiting, business strategy, and customer development. That’s compared to larger firms, who have dozens (perhaps even hundreds) of seed investments and where founders can easily feel abandoned and without any support. “We win every time when founders talk to our portfolio companies,” was the general sentiment.
And yet. For founders living and dying by the ambiguity of their market, their product, their talent and their future, that imprimatur of a big-brand-name VC firm — even with paltry founder recommendations — is extremely hard to turn down. As a founder, do you want the VC who is going to work his or her ass off to help build your company, or the VC whose selection of your startup gives you (and likely your employees and your customers) the peace of mind that things are going really, really well?
The sense I get is that the viewpoint is shifting to the former from the latter, but the reality is that most founders can’t turn down the allure of the big name fund, even if they get an abundant set of glowing references about a lesser-known firm. Ultimately, that hard-working VC can help you with key hires and customers, but the reputation of a big firm will grease the wheel of every decision that gets made about your startup.
VC signaling
The other line of responses I got — including an extensive missive from a partner at a top 20 firm — is that VC signaling still limits the impact of a lot of the largest funds to invest earlier. Founders realize, the thinking goes, that taking money from a fund that can lead the next three rounds is bad, since if their investor doesn’t lead those rounds, it signals to other VCs that something is wrong with the company.
I increasingly feel VC signaling is a completely phantom pattern these days (disagree? Tell me your story → [email protected]). Not only do I think that VCs increasingly ignore these types of signals, I think the VCs who hustle the most aggressively are targeting the early seed checks of other funds in particular and intercepting their best deals.
Why does this work? For one, large firms haven’t really figured out how to manage the information flows from hundreds of portfolio companies simultaneously, so they consistently miss the inflection points of their own startups — points that smart VCs with good noses for opportunity identity faster.
Second, there is indeed something about referenceability and founder abandonment — a number of founders have told me that they send out a multitude of tweaked investor updates that include more or less information based on the relationship they have with an investor. Often their lead investor is getting the least information — and doesn’t even realize it. It’s a subtle hack for handling what could otherwise be an awkward situation. It also helps to create FOMO around a round that is particularly exploited by startup angels eager to find the largest early uptick in their portfolio.
Third and finally, as with all good VC investors, seeing an investment with a fresh pair of eyes rather than through the cynical air of experience can often lead to radically different investment decisions. An incumbent investor may have heard all the data and promises from a founder for one, two, or three years, and fails to see the slight changes happening at the end, while a new investor without that background can make a new decision based on the best evidence in front of them today.
The lesson to me isn’t that investors suddenly decided to ignore signals. It is that with so much competition for startup cap tables, having the right numbers and a great product story and narrative will overcome any other VC signal, positive or negative. And for the VCs themselves, there’s nothing quite like snatching the best golden egg from a competitor’s nest while they are out flying around searching for the next great deal, which if they had looked a little closer, just happened to be right in front of them.
I’m still going through some of the comments I received on last week’s articles about the heightened competition among VCs for the best (typically SaaS) venture deals. Some more notes on whether large funds investing in small rounds causes VC signaling risk in a moment, but first, a fun anecdote…
