Measuring Investment Performance by Measuring Deal Flow

In the past week or so I’ve been asked by a couple up-and-coming VC fund managers what investors really want to know before they’ll invest in a fund. Without much concentration, I think it’s easy to say that most investors want to know about current and past performance. But if you think about this question from a different angle, I believe investors also want to know ‘what is the source of performance.’ It’s easy to spit out numbers, but sometimes numbers don’t tell the whole story, especially when investing in venture capital. An additional question investors should (and usually do) ask is “What is your process for maintaining access to great deals?” Without great deal flow investment performance is likely to suffer.

In real estate, “location, location, location,” is usually the number one driver behind a property’s performance. If a real estate developer builds a 5-star hotel in the middle of the projects, that hotel is likely going to fail. The same concept that applies to real estate also applies to investing in early-stage companies, with a few minor differences.

There are several facets to accessing good, quality deals (i.e. companies). However, for the purpose of this post I’m only going to discuss the three that I believe are the most important. First, there is geography; second, there is reputation; and third, there is curation.

Similar to real estate, the location of a venture capital firm (VC firm) plays a major role in the availability of good deals. Ideal locales include areas with bustling business districts, prominent universities, and a large and diverse consumer base. In areas like this you typically find the business community is composed of previously successful entrepreneurs who are now themselves investing in startups. You’ll also find universities with programs designed to encourage and show would-be entrepreneurs what it takes to build successful companies. These universities usually offer courses about venture capital taught by actual venture capitalists. Lastly, a locale with a large and diverse consumer-base acts as a great testing-ground for marketing innovative ideas crafted by creative entrepreneurs.

Regardless of industry, having a good business reputation is critical. For VC firms, reputation is everything especially as it relates to attracting top-notch talent. More experienced entrepreneurs spend time researching venture capitalist’s background before ever making contact with the firm. If the firm in question has a poor reputation for being harsh to entrepreneurs by demeaning them in meetings or offering unfriendly deal terms, that firm is likely to miss out on good opportunities. On the contrary, if the firm has a reputation for helping entrepreneurs with strategy, product development, building strong management teams, and offering balanced deal terms, that firm is likely to attract and have first dibs on better opportunities.

While a VC firm’s geography and reputation are important, these elements are hard to optimize without a consistent focus on deal curation. I equate the effort a VC firm puts toward curating deals in the same way a star-athlete puts effort towards maintaining her elite, athletic prowess. This may seem contradictory to the statement above about VC’s ability to attract deals simply because of their good reputation. But it really doesn’t because active curation involves engaging in activities that reinforce a VC’s position amongst entrepreneurs (and other VC firms, for that matter). Such activities include hosting open-houses to allow entrepreneurs to get to know their investors and fellow entrepreneurs; routinely publishing helpful articles or blogs about strategy, business development, latest trends, etc.; speaking at trade shows and conferences and positioning one’s self as an expert in a particular area. One of our portfolio VC firms had a brilliant idea to purchase and send an interesting book out to their network and later invite the recipients to their office for a fireside chat with the author of the book. Not only was this different, it was quite creative. I believe this serves as a good example of how a VC firm is enriching the entrepreneurial and VC community by taking an active approach to reinforcing its standing and reputation. It is an active approach to curating deal flow.

At the end of the day, the objective for any investor is to make a profit on their investment. Because it takes so long to reap the rewards of investing in venture capital, it’s critically important that VC firms focus their efforts on securing good companies to work with on a consistent basis. Because there is such a high propensity for failure with early-stage firms, it’s important that VCs make every effort to invest in the best companies, with the best teams, in the best markets, every single time, and with no exception. Investing in this manner doesn’t guarantee every investment is going to be profitable. However, VC firms that are able to invest in this manner are usually the ones who are consistently top-performers. Cheers – KM


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