I get emails and DMs every month asking for advice on how to raise capital from top venture capitalists. Depending on the day, I don’t have the heart to tell them how improbable it is if i’m the closest connection they have to the inner circle. This is because venture capital isn’t built for outsiders. Just like you need to move to Hollywood if you want to make it in movies, unfortunately the same is true for the Bay Area. If you want to raise capital from a tier one firm, which has countless downstream impacts, ideally you do so from one with ties to SF. The goal is this post is to shed a perspective that you may not spend much time thinking about; why the system works in the way it works. I want to start this post off with a look into the forces that the other side of the table is dealing with.
Venture Capital Is Harder Than it Looks
Many first time founders based on the outside of the bay might undervalue how hard it to be a good venture capitalist. Being a good VC doesn’t mean just picking deals. To be a good VC means focusing on three core areas and excelling: raising money from investors (LPs), taking that money and investing it into startups, which hopefully yields a return of 3x on that portfolio within 7-10 years. Let’s break those down one by one.
Raising capital from limited partners
Did you know that VCs need to raise capital, just like founders do? They don’t invest only their their own money, unlike angel investors. Venture capitalists raise a fund to then invest out of. The VC firms you’ve heard of likely have multiple funds. A venture capitalist spends months, if not years, raising money from potential LPS, so then they can put that money to work. The type of investors that VCs look for are often family offices, fund to fund VCs, or high net worth individuals. This also isn’t a one time activity. VCs go out and raise new funds every 3-5 years so they can keep deploying capital into startups, and hopefully making money in the process. If you ask many VCs, they will say that this is likely one of the most time consuming parts of the job.
They take that money and put it into startups
Raising capital from LPs might be the most time consuming, but investing in startups to get a decent return is, in my opinion, the hardest. Why? Well there are a ton of factors at play here. Some of them are:
- Picking the needle in a haystack
- Having “access” to the deal
- Owning a large enough % to make a different in the fund’s performance when the company exists
This is far more nuanced than many founders realize. And the job is nearly impossible, which is why so many VC funds underperform.
Picking a needle in a haystack
The questions is this. If you’re getting 1,000 inbound deals a day from a variety of different sources, who are going to be the 20 or 30 you respond to and take a meeting with? Or in other words, who will be the 90% you ignore? There is why VCs rank their deal flow. Usually warm intros from other founders in their portfolio is at the top of the list, then introductions from other VCs, intros from friends, and far down the list are cold reachouts. So just note that if you’re a founder cold emailing a VC, wondering why she isn’t responding to you, it’s because she has so many other deals to look at that are potentially higher quality than yours. How can they know that the other deal flow is higher quality? We’ll get into that later in the post.
Having Access To The Deals
There’s a well circulated idea that to be a good VC, you need deal flow AND you need access. Just because you know that a deal exists, doesn’t mean you’re able to have access to that founder or access to invest. Most of the “having access” part is work done before the deal even comes up. Access is given by having a great brand, other great portfolio companies, a great network, etc. So ideally, when a hot deal comes across your desk, you don’t need to fight to get access to that founder, because you already have it. Many times, a deal will come across a VCs desk, but they don’t have access, and they aren’t able to invest. It’s in a VCs best interest to create as much access for themselves as possible.
Own enough of the companies to matter in the long run
Once a VC has access to invest in a deal, this isn’t enough. The VC needs to fight to get their share of allocation that makes sense for their firms portfolio strategy. If a hot deal is raising $5M, but only has room for you to invest $50,000, even if it’s a unicorn, it doesn’t matter. Your ownership will be so low that you will get diluted into oblivion during subsequent financing stages. This matters because you aren’t fighting for ownership for yourself, you’re fighting to get ownership for your LPs. And if this company is one of your big winners, you want to make sure to own enough of it so it can cover the whole portfolio. If you owned .0005% of Uber when it went public, it would feel good, but it wouldn’t produce the financial returns you promised your LPs. So it’s not just about finding the deals. It’s not just about accessing the deals. It’s also about owning a significant % of your winners, to cover all of the losses in your portfolio.
Aiming for a 3x venture fund return within 10 years
So once these VCs invest in one of these companies, now they need to help make sure the company is successful. This means a multitude of many things. This could mean helping the CEO with big decisions or attracting potential hires. it could mean helping with a M&A deal, and it could even mean just supporting the founders, mentally. At the end of the day, most of the control is with the founder. A VC can only do so much. But, if the founder is executing and increasing the value of the company on a quarterly basis, it’s an investors job to keep putting money in, as long as it fits the portfolio strategy of their firm. So for every new financing round, the VC can put more money into the company to maintain their ownership % (as long as they have pro rata).
Note, although VCs have high conviction when investing in companies, most of the investments go to zero. So if a VC invests in 10 companies, most of them will likely go out of business. A couple might lead to modest exists, and one might cover the whole portfolio. Their goal is to own as much as possible of that one company, so when it does exit, it doesn’t just make its money back, but covers the losses of all of the failures and singlehandedly gets that fund to a 2x or 3x on the capital raised. This is what we call a “fund maker”.
So, there you have it. That is a large chunk of a VCs job outlined in a couple of paragraphs. So why does any of this matter to you? Well, it’s everything. The point I wanted to make above is that venture capital is hard. It is MUCH more than investing in good companies. The economics of it are challenging. This is the core of why the system works how it works. You may be asking, “what is the system?”
Understanding the Rules of The Bay Area
There are tons of people right now who are likely sending sold emails to investors, trying to convince them to invest in their company. The reason people do this is because they have no other way to get to the VCs. They don’t have a warm connection to ask. They don’t even know who is in the inner circle. All they know is how to build companies. And they probably are pretty dang good at it, which is why they are trying to get a VCs attention to invest in them. The challenge with this is that the whole game of venture capital is less about business building and more about understanding the fundraising game, and then playing the game. If you can grow a company quickly, more power to you. But if you don’t know the implicit rules of how the Bay Area works, you may be a more risky investment than the Bay born Stanford grad that knows everyone, even if they just have an idea. The reason for this is that this Stanford grad is already in the network. People know them and trust them. But most importantly, this Stanford grad understand the rules of startups, and this makes them most investable. It’s worth explaining how some of these rules work.
VCs are in the business of filters
Venture capital is made up of all different filters. These filter are synonymous with trust building. The more trust you have within the inner circle, the closer to the center you become.
Y Combinator is a filter. If you got into YC, you must have a certain level of intelligence. Same as working at Stripe or Pinterest. If you got a job at one of these companies, you must be smart. Other filters could be previous projects you’ve built. Learn more about filters here
The challenge for VCs is that the filters still let a ton of people in. They may get 20 warm intros from their portfolio founders, 12 YC companies pop up that interest them, or a company their friends invested in is looking to raise a round, all within a few days. Oh, and then there’s all the cold inbound from founders like you and me, who have no access to their network. When evaluating all these opportunities, they use filters to decide where to spend their time. If someone couldn’t even complete the founder litmus test, they likely won’t get a meeting with a VC.
Note, this isn’t because your business is a bad business. It’s that VCs operate on pattern recognition and on filters. When you land on their desk, with no warm intros to do reference checks, no context on your background, and no idea about your company, it’s hard to justify spending time to learn more, especially when the opportunity cost would be missing out on all these other deals that they can better understand via pattern recognition or through filters. Is this far? No. But business isn’t fair, it’s about who you know and who knows you.
You don’t need to have one of these filters out of the gate in order to be taken seriously in the Bay Area. For example, one way to break in is by the founder test.
The Founder Test
There is a trick that investors and insiders know, and they wait to see if outsiders know this to evaluate if they should respond or take a meeting. Outsiders who know how the game works will need to find a way to befriend a few insiders, only then to get a warm intro. Cold emailing a VC is easy, but getting to know one of their portfolio companies, schmoozing with the founder, and then getting that founder to make a intro to that investor for you, is playing insider mentality. To a venture capitalist, this is the first test to see if an outsider is even worth meeting. If they aren’t street smart enough to learn the rules of venture capital and the bay area, they aren’t worth the VCs time.
Let’s say a founder gets an introduction to a venture capitalist from his/her portfolio, and they actually like them and decide to invest. Well this allows the outsider to slowly peel back the onion that is the Bay Area. Just because a prominent investor invested in you doesn’t make you an insider. What it does is communicates trust within this tight network. If a prolific investor invests at your seed stage, it sends a signal to everyone else is SF that you are credible enough to get X investor, and creates a fabric of trust around you. More particularly, it creates a filter.
VCs can’t look at every opportunity
If you understand the power of filters in the VCs world, you realize that if you are not being filtered through, they don’t care to meet you. I want to reiterate, this is not because you don’t have a good business or you’re not worth meeting. This is due to the fact that venture capitalists have 24 hours in a day. Look at it like this. Because they know that YC alum perform well, she puts them in a bucket. She puts the CS grads from Stanford in another bucket. And the MIT team in another. And when looking at who she wants to meet, she evaluates all the opportunities based on those filters. They don’t do this because they hate outsiders. No no no. They do this because they want to make sure they keep their job and thrive in it! So they do what has worked in the past.
If you’re a founder from Phoenix with no filters that a VC traditionally looks for, you likely won’t get a meeting because there are other opportunities for that VC that better fit their filtering system. Not that you are bad one. It’s like, if a VC had one meeting slot, to meet you or Travis Kalanick from Uber, who would they pick? Yes, Travis. So extrapolate that out. VCs are in the game of picking. Picking the right startups to meet with, so they can pick the right ones to invest in. And filters (pattern matching) is a way that VCs can best do this to do their job right.
There are negative filters too
Note, there are filters that VCs use to filter founder out of their focus as well. For example, if you send a massive pitch that includes your life story to a VC over email, they will think you’re too early or too raw of a founder. If you are based in a geography that investor doesn’t invest in, that’s a filter too. Note, these aren’t good or bad. They are tools that VCs use to do their job. Unfortunately, these filters from top VCs in the. Bay Area follow a different rule set than the ones in the rest of the worlds. Filters are a common tool that all VCs use, but the type of views towards the market only exists in the Bay Area.
SF Operates In an Expectation Market
In the bay area, the potential of a founder or company is much much more interesting than realized potential. I’d argue that the hottest startup out of YC this last batch has more power than some of the top tier venture capitalists in the. Bay Area. The reason for this is that these people have already found their success, and although they may be able to find more, the multiple of success is lower. Just like a stock, unless you’re Tesla, the potential of a recently IPO’d stock is more interesting than a Proctor and Gamble. This explains a lot of the abnormal behavior that occurs in the valley.
A pre-launch startup is more interesting than a post-launch one
The pre launch startup only has ideas, vision, and potential. There is no data to go off of. There is only dreams to believe and a team to trust. And when all there is is potential, this is the only thing that drives the data. So, this is why the valuations are so high in SF. Founders are able to paint a billion dollar vision, and investors either believe it and invest, or call rubbish and ignore. This is harder than it appears, as Paul Graham points out, one of the two larges fears of investors is investing in a dud and missing out on a rocketship. When #1 is realized, the worst case is losing 1x the investment. But when #2 is realized, then the potential losses are enormous. It’s easy to say no, but hard to live with yourself if that company becomes Uber. And this is the power of the pre-launch startup. If you get a founder with a ton of charisma and salesmanship, they can convince people into the vision. And if they can’t maybe they can convince them of what will happen if they pass. This is where FOMO comes into play. And this is why these pre launch startups are valued as highly as they are. Yet, this knowledge only works in SF. There is no other market in the world that follows expectation markets like the Bay Area does. Everyone else follows the performance market.
The Performance Market
If you’ve already launched, then yes..there’s vision, dreams, and potential. But there’s also hard data on how you’re doing and executing. If you’ve launched, investors can look at your revenue growth or user growth. Sure, the vision is compelling, but does your growth rate line up with your vision? No? Ok, come back in a few weeks with more traction. This is challenging, isn’t it? If you’re an outsider with a great team pre-launch, then VCs will say that you need to ship something and get it to market, because you don’t fit their filters. Once you do that, they will look at every data point and see every reason in the book to not invest in you, because you are out of the expectation market. This stacks the cards in favor of insiders. People with access. People that know the other funders and founders in the scene.
You could argue that all founders should go through the “founder test”, which is a right of passage in the bay area. but unfortunately, I don’t think that these founders even know the test exists. They are business builders, not FOMO generating hype machines. I’d argue the founder test would be a waste of time for them, because the whole reason they’d want to raise money in the first place is to grow their business. And I think this is the key difference between outsiders and insiders.Insiders know the rules of the bay area and sometimes know the rules of business building. Where outsiders know the rules of business building but rarely understand the rules of the bay area.
The Great Paradox
This is a paradox. If the point of raising capital is building a big company that creates ton of value, you’d think a founder focused on this from the get go would be interesting to VCs. Yet, it’s really the founders who know the right people who get the swings at bat. I personally think that this is the reason that most venture funds actually underperform. Many of the founders they are funding are just playing the rules of the game, not actually building a business. And the VC market rewards this. The people attracted to starting startups move to the bay, learn the rules, play the game, get capital, then think about company building. Where on the contrary, you have people building real businesses that could be 10xd, or 1,000xd with capital, but because they aren’t in the right networks, they have no chance to get the time with a VC to explain that their company is actually doing very well. The only way they can do this is if they get lucky, or if they do the founder test. Which actually takes them away from their business to learn the rules of a game that they probably don’t even want to learn.
The venture capital market should change
I want to point out, I think these contrasts are borderline laughable. To think that the founder who plays the FOMO game, can raise $2M on a $15 post money round pre product…but the founders who launched and are growing can’t raise $1M on a $5M post just makes me scratch my head. Yet, this is the culture that is the Bay Area. They believe in expectation markets far more than ones based in reality. Still, you can’t blame them for keeping at it. Time and time again, the Bay Area delivers incredible companies to the world.
These rules brought us Uber, Google, Apple, and many others. It’s hard to disagree with the logic when such a small asset class dominates such a large percentage of the stock market. I’m typing this post out on an Apple Macbook. I am using the Substack editor. I am sharing snippets on Twitter. All of these products are built by companies that are VC funded. It’s hard to argue that the system doesn’t work. It does, and it’s rooted in prosperity and success. Unfortunately, it’s only rooted in prosperity and success for those who play the game. Does that game make logical sense? No. Does it work? Absolutely. And as long as it still works, anyone trying to make the Bay Area change or bend to their will is going to fail.
And this is why venture capital isn’t built for outsiders. Because even if outsiders have better businesses. Even if the outsiders have better teams. Even is outsiders have better opportunities. Most of the sophisticated startup capital is based in the bay area, and this capital doesn’t care about your business fundamentals. This capital cares about moonshots. And in a world where moonshots happens more regularly than not, this capital would rather be invested into 100 insane Stanford grads trying to change the world, vs. a business already being built growing 15% WoW in Montana. For better or worse.