4. Searching for Outliers: Evaluating VC firms

Hey there,

Welcome to where I write about my journey from a stable Big Tech Software Engineering job to the wild and volatile world of Venture Capital.

So you’ve survived VC interviews, and received an offer, how do you evaluate a firm and know it’s the right one to join?

Like I mentioned in a previous post, the financial outcomes of an employee at a Top VC are significantly better than at an average firm:

Why do Top VC’s significantly outperform the rest and how do we identify a Top VC?

Top VCs and Power Laws:

In most natural populations, outcomes follow the Normal Distribution or the standard Bell-Curve you might remember from school. The majority of results cluster around the mean and the median, results are symmetrical, and as you move away from the mean, the number of outliers rapidly decreases. Normal distributions are what we’re used to, they frequently occur in things like test scores, heights, IQ scores.

Power law distributions exist in systems that are winner-take-all markets.

For example, the global distribution of wealth follows a power law distribution.

According to a 2023 Credit Suisse Global Wealth Report, the top 1% of the world’s population (outliers with > 1,000,000 USD net worth) own 44.5% of the the entirety of the World’s wealth, whereas 53% (2.3B people) have net worths less than 10,000 USD. This discrepancy get’s even crazier when we add a slice for the 0.1% (extreme outliers with > 50,000,000 USD net worth), who own 20% of the world’s wealth. 🤯 

Sadly, I can’t solve global wealth inequality in this post, so let’s get back to talking about VC. 😭 

VC fund performance also follows a power law distribution, in which the top firms produce the majority of returns for LPs. There are many reasons for this:

• The markets that startups are attempting to take over are winner take all markets. There is only 1 next Nvidia, Microsoft, Apple, Google, or Amazon.

• These startups typically only partner with a handful of the best VCs for funding, brand recognition, support, and connections.

• LPs (of which there are less than VCs) know that the best VCs have the best returns because they have the best startups. The best LPs only partner with the best VCs.

• This cycle perpetuates and further exacerbates these uneven distributions. 🌀 

Evaluating a VC

So, we’ve come to the conclusion that we want to join a top firm, how do we find one?

A quick and fast way is to look at the Midas List to see where the top partners work.

Realistically though, these teams are extremely difficult to get into and very crowded (unless you’re a man in Finance, with a trust fund, 6’5”, with blue eyes). What other ways can we evaluate them?

Track Record and Performance

I like to put my LP hat on when assessing the performance of a fund and look at these key metrics:

1. Internal Rate of Return (IRR): This measures the annual growth rate of an investment as a percentage. The expected IRR is around 20%, higher the better.

2. Multiple on invested capital (MOIC): A straightforward metric that just tells you how much the fund is projected to be worth divided by the initial size of the fund.

3. Distribution to paid-in capital (DPI): Of the money paid in, how much has been paid out (distributed) to the GPs & LPs. Over the lifetime of a fund, the higher this gets the better, and a 0 means that the fund hasn’t generated any money yet! A 0 in a new fund that you’re participating in is totally fine, but looking at the DPI of previous funds is a good indicator of projected performance.

4. Fund Size - Typically, top tier VCs have large & oversubscribed funds. More capital means more chance to identify the next big thing.

(Caveat: VCs may hold these numbers pretty close to the chest, but if you’re considering a firm, I imagine they’ll give you this info under NDA. If they refuse, this is a bad sign! ❌ ).

Team and Expertise

Has the team been successful founders or operators? Do they have a diverse and impressive background? What networks can they tap into, and what expertise can they provide companies?

Typically you can read press releases about them or read some of their writing. Self-promotion and marketing is a big part of VC (🤮), so try to find objective sources.

What do their LPs look like? Large institutional investors like university endowments (Harvard, Yale, Stanford, etc) are a good sign.

Portfolio Composition

What companies has a firm invested in? How are those companies doing? Are they likely to be winning their market?

Unicorns, decacorns, successful public exits are all good signs that the firm can identify winners.

Reputation and References

Reach out to people who have worked with the partners or other prominent team members. Do people like working with them or do they have sharp elbows? Do they get shit done or are they all talk? (Counterintuitively though, hot air balloons can have a string of successes 🎈 🎉 )

Talk with founders that have been funded by the firm, other VCs, people in the industry. If people light up with excitement talking about an individual it’s a good sign. (If they quickly change the topic, run away 💨)

Evaluating a VC firm to join is not a simple task. It goes beyond just looking at the financial outcomes. Consideration of the fund's track record, team, portfolio, and the reputation are all crucial aspects to consider if the fund is going to be an outlier. Good luck!

Ok, that’s enough about evaluating VCs, next post we’ll find out what it’s actually like to work at a VC and what my first week was like … 🥹 

Until next time!

Signing off and signing zero checks,

SWEdonym

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