Bruno Teixeira
By any measure, investing in seed-stage companies is a risky business. It is risky because these companies are just scratching the surface of the kind of challenge they will face in the future, and figuring out the drivers that will ensure adequate return on investment is not that easy (or nearly impossible).
Given this risk profile, the expected return of such investments should be higher than that of stocks, bonds or most other publicly traded securities. In the world of legal investments, seed-stage VC should be up and to the right on the risk/return chart.
For a VC fund to succeed in the classical sense, 'which means actually returning capital to its limited partners (LPs) and generating performance fees for the general partners (GPs)’ and be considered top-tier, it should return at least three times the capital invested. If around 90 percent of startups die statistically, then 10 percent of the portfolio should generate all the returns. On a simplified view of the world, where equal amounts are invested in each portfolio company and fund fees and costs are zero, this implies that the 10 percent should return 30 times whatever was invested so the fund can provide 3x distributed to paid-in capital. In the real world, less than 10 percent of all VC funds generate that kind of return and the industry mean is a little over 1x.
So, where does the mojo come from?
Unsurprisingly, it comes from the ability to find the best investment opportunities. But, as observed in the example above, high-return opportunities are elusive creatures that show their faces only to trained or lucky investors. Although luck is normally the most relevant variable in any market model, relying on it does not seem like the best strategy for a VC firm to succeed. As Seneca is supposed to have said, "Luck is what happens when preparation meets opportunity."
Having a method does not mean anything if the ones operating it do not live and breathe by the values behind its creation.
Setting aside the ability to originate high-quality deal flow, which has a lot to do with how well connected the GPs are and how desirable the VC firm is to founders, among other things, how does an investor figure out which, out of all pitches decks they receive, are the ones to pick?
Of course, each firm has its own view on this. And we, at Raio, have our own way of looking at it. We believe that one should start by admitting that one is clueless, lost in a universe of infinite complexity where models are bad predictors since the most relevant variables are not easily observable. By being honest about this (to ourselves and to our stakeholders), we create the possibility of feeding from it instead of falling victim to it. We embrace the fact that seed-stage investing and, to different degrees, all investing relies mostly on intangible variables and that we are flawed observers full of biases and prejudice, and we incorporate all that into our decision-making process.
The way to do this, which seems challenging at first, becomes clearer once you step into design thinking and the designer's view of the world. A designer creates prototypes and validates her hypotheses before leaping into a final solution. To us, this solution is never final. Our investment analysis method is built upon a series of steps that analyze the variables we deem more relevant and is, in itself, a permanent prototype. We incorporate learnings from past decisions, combined with new ways of looking at the world into the analysis process on a never-ending iteration built to evolve forever. By endlessly fine-tuning our model with real-world data collected in the numerous interactions we have with investment opportunities and creating steps that are meant to de-bias our opinions, we are able to get incrementally better every day.
Something like this is only possible if one's objective is to function at the highest levels, where there is a culture that can back this mindset up. Having a method does not mean anything if the ones operating it do not live and breathe by the values that were behind its creation. In order to operate within the method I propose here, a firm should stand on a culture of curiosity, diversity of thought, respect, authenticity, transparency, and detachment from ego.
