Office hours on VC and startups, open to everyone

Twelve questions on venture capital — why VCs push for growth, what makes a founder fundable and how to tell skill from luck

These are office hours I typically reserve for my Stanford students. This time I opened them to everyone.

I received dozens of questions on all VC-related topics. In this post I answer 12 of them — on why VCs push for growth, what makes a founder fundable, how to tell skill from luck, and what to do if you are one of the 199 startups out of 200 that will never raise a VC round.

The next Q&A will be in the Substack chat, so prepare your questions.

QUESTION 1

Why do most VCs care so much about immediate growth speed (versus quality) and have such short ROI horizons?

A great and important question. Let’s start with ROI (return on investment) horizons. To understand what is happening here, I will start with three relevant factoids. First, most VCs invest through VC funds they raise from LPs (limited partners who are capital allocators such as pension funds and family offices). We are accustomed to using “VC funds” and “VC firms” interchangeably, but they are different beasts. I often say and write myself “such and such is working at a such and such VC fund,” but really the “employment” is through the VC firm management company. A VC fund does not have employees.

What is truly critical about VC funds is that most of them have a limited horizon. Traditionally, the horizon was 10+2 years (ten-year contractual horizon and two annual extensions), but more recently actual horizons got extended and often are 15 years. But whether it is 10 years or 15 or even 20 years, what it means is that VC funds are temporary creatures: they are raised, the funds are invested, portfolio companies are managed, investments are exited, capital returns to LPs, and then the VC funds are liquidated. (If you are asking why VC funds have finite horizons, I devote lots of ink to this in my private equity course, which will be on my Substack soon! Suffice it to say here that there are lots of good reasons for it.)

This temporary structure and limited horizon mean that VCs can’t just invest and wait forever; they need to ensure that these investments — at least the successful ones — will return money soon enough. “Short” does not mean one day or one year here, but VCs just can’t afford to invest in, say, a project with an expected ROI horizon of 20 years.

The second factoid is that VCs raise more VC funds as they go along. Really, the main purpose of raising the first fund is not to make money off the first fund but to raise the second and then the third VC fund that will hopefully be larger and even more successful. VCs try raising VC funds every two to five years. But ... imagine you are a VC and you are raising your second VC fund three years after you started investing from your first VC fund. You go to your current LPs and to your potential new LPs and they all ask: great, please show me what you have done so far. What you need to demonstrate is how your current VC fund — after three years or so — is performing. You may not yet have made much cash for your LPs, but you do need to show that your investments are performing well. Meaning, their valuations go up, they raise more rounds, and all of this requires that they show some kind of ROI. So in reality the horizon is not 15 years but much shorter: the signal of performance must come within a few years, or few people will give you more money for your next fund.

The third factoid is that the VC industry is illiquid. Meaning it is rather difficult for anybody (if you are an employee of a startup, you know!) to sell their shares on the open market. This is not your New York Stock Exchange. VCs are unable to sell their shares at their whim. They can’t exit their investments at the time of their choice. Meaning they can’t really produce ROI on demand and lock in their returns. (Those in the know will respond that the secondary market is on the rise. It is, but it is still small and really functions only for the most successful startups.) Again, illiquidity has its own deep reasons, but the simple fact is that VCs are locked in to their investments more or less until the startup goes public or is sold (or fails, but then you don’t get much anyway). And it takes lots of time for startups to achieve an exit outcome. SpaceX took more than 20 years to go public, and these days an average startup takes up to 10 years to achieve a successful outcome.

Ok, now that we are in possession of these three factoids, we can explain why VCs care so much about immediate growth speed from their perspective. VCs need to know how their startups are doing and need to know this within a relatively short horizon. If it takes years for startups to showcase their viability and business model, ROI will be low or non-existent.

There are also startup-related deep reasons. Startups also raise funding often — on average every 15 months or so — and a successful startup often raises more than six rounds of funding. But to raise another round of funding, you need to demonstrate you are doing well. The clearest way to do so — especially after you emerge from the pre-seed stealth stage — is to demonstrate growth, meaning customers are actually interested in what you do and flock to you. And let me add another reason: if you don’t demonstrate growth, your competitor may. As I tell my MBA students, for each Uber there is always a Lyft, and if you don’t succeed, and fast, you will be overtaken soon enough.

Let me address the final point: the question is asked using negative overtones (growth vs quality comparison). I don’t think it is justified. The VC industry is good at what it does — and it is not very good at what it is not built to do. Seven of the 10 largest companies in the world are, at the end of the day, VC-backed, and had there been no VCs, our lives would have been very different. But if we want to invest in projects that require ultra-long horizons and do not show their quality for years to come, the traditional VC industry is not positioned to do it well — and, frankly, neither is almost any other privately financed industry. As a result, there are some other solutions that are being developed, such as impact VC investments that are structured differently and potentially can tackle, say, very long-term climate projects. As an economist, I am somewhat skeptical about the sustainability of these setups without long-term government funding, but that is another discussion.

QUESTION 2

What type of founder do VCs light up for and decide in favor of? Does that pattern hold across the whole partnership or just certain partners?

Another great question that I have done a lot of research on (check many of my LinkedIn and Substack posts on this). Founders and employees (don’t forget about employees!) of early-stage startups are critical and by far the most important factor in a VC’s decision to cut a check. In my book The Venture Mindset, co-authored with Alex Dang, we even devoted an entire chapter to this issue. I would briefly outline several characteristics that in my experience VCs care about, but let me preface that there are differences among VCs -- and it is only partly science and mostly art.

I would list the following five characteristics as important: perseverance, flexibility, depth, charisma, toughness. I will devote just a couple of sentences to each — there will be an entire Substack post just on this.

• Perseverance: every successful startup has had a near-death experience, and repeatedly. A founder who gets frustrated easily when they hit a wall is unlikely to be successful. Beating against the wall, trying again and again, persevering in the face of challenges, is critical.

• Flexibility: perseverance does not mean stubbornness. As ideas hit reality, founders get valuable feedback on what works and what does not. Making changes in response to this feedback is not easy — including psychologically — and being flexible while being persevering at the same time is another critical quality.

• Depth: Many VCs tell me they are looking for founders they can learn from. Founders who know their space better than anybody else, have looked into every nook and cranny, and are ready to execute on it have a much higher chance of success.

• Charisma is difficult to define but when you see a person with charisma you see it quickly. Yes, we have all by now heard about one guy building a unicorn all by himself, but great companies are built by a team. Your ability to find followers who are ready to embark on your ship before it even has its first mast is difficult. Getting the best employees before you have money, resources, product, etc. is tough. Charismatic leaders get these followers. I have been very lucky to have met many of my students at Stanford who have charisma. You can say I have been spoiled.

• Toughness: Tough and unpleasant decisions need to be made: laying off employees, saying no to customers, negotiating with investors. VCs are looking for sufficiently tough founders able to push through difficult choices.

QUESTION 3

VC returns are so concentrated in a few outliers that almost any story can look right in hindsight. How do you separate genuine, repeatable investor skill from survivorship, where luck just gets narrated afterward as a ”mindset”? What in the data would actually distinguish the two?

Luck does play an important role in VC. But when I observe that some VCs get “lucky” again and again, it is no longer luck. If I win a jackpot in a lottery this week, it is luck. But if I hit the jackpot again next week, it is no longer luck — it is skill.

The VC industry is remarkable: it is really the only type of financial intermediary where we see significant evidence of persistence — the ability to hit jackpots again and again.

The way I separate luck from skill is to check persistence. One successful outlier does not prove skill, but outliers are rare in VC (historically, around one out of twenty early-stage deals is a home run or fund returner), so once you have two outliers, you should start paying attention. There is a statistical way to study and check persistence, too, but even a visualization of successes allows us to identify VCs that capital allocators and founders should pay attention to.

Important note: pay less attention to failures and more to successful outliers. One exception is the “spray and pray” strategy, where you invest in hundreds of deals and you are more likely to hit some outliers. But once the ratio is one out of 20 or better and there are repeated successes, it cannot be simply dismissed as luck.

QUESTION 4

Could a VC that focuses on developing Mittelstand startups instead of big unicorn bets financially work?

Under the current business model of the VC industry, it can’t. By definition, Mittelstand startups are those that are more likely to become successful middle-size companies. VC is all about taking high risk and often expecting high losses. These higher losses need to be balanced by successful outliers.

So if by “startup” we mean a risky company offering something new with a high chance of failure, the Mittelstand business model would not work.

QUESTION 5

How can more socially useful / innovative (deep tech) startups get funded, instead of only SaaS and AI startups?

Well, it is one of the VC myths that only AI startups get funded (and I am less sure about SaaS startups these days — just check what is happening with many large SaaS players). I recently collaborated on a deep tech report, and not only are there hundreds of deep tech startups that get funded month after month, but their number is growing. Take, for example, robotics and anything defense-related. Take bioengineering. Or take quantum computing or nuclear fusion startups, which did not exist even several years ago and to which the VC industry is now allocating billions.

The point is different: If you are a deep tech founder, the criteria by which VCs will be evaluating you are different. Too many founders are not prepared for this and so they can’t raise funding. This is why I opened my VC class here on Substack — so that founders, including deep tech ones, understand what they really need to do to fundraise successfully.

QUESTION 6

VC conversations bring positive feedback on market readiness, product, IP, team, and early traction — but the process stalls because of unspoken concerns or missing signals not explicitly addressed in the pitch deck. It feels less like ”the idea isn’t good” and more like investors couldn’t fully de-risk conviction from the deck and passed. How should a founder handle this scenario?

I feel this question comes from experience. Have you checked my checklist for founders? A simple way to address this is to anticipate what VCs will be asking you, what they care about. Too many founders in my experience never try to fit themselves into investor shoes — and they should.

It is not about anything missing in the pitch deck — it is a signal to the investor that the founders don’t care about this or that important aspect, and VCs know from their experience this will likely sink a startup.

If “the idea isn’t good,” you don’t get to the pitch deck stage. Investors are ready to take risks — but they need to know what kind of risks they are taking and whether you, the founder, know these risks.

QUESTION 7

Say there’s a very young founder with no pedigree and just an idea (with very good data validating a big opportunity). Is it possible any type of investor — angel or VC — funds them?

Absolutely. Y Combinator, for example, accepts mostly founders without any startup experience. If by “no pedigree” you mean no education or work experience, it is tougher, but it all depends on your ability to stand out and showcase the five qualities I identified above in answer to another question, plus proving that your idea has potential and that you are a good fit.

In my cold outreach research, one out of six to one out of eight VCs responded to founders they had never met because they were intrigued by an idea and the description.

QUESTION 8

What should the other 199 startups (out of 200) who do not receive VC funding do instead?

It all depends on what you want to achieve. Most startups should NOT be targeting VC money. If you are not a high-growth startup with the potential to reach billions, perhaps VC is not the best outlet. There are many other opportunities: angels, incubators, grants, or perhaps using only your own and your friends and family’s cash to get started. Many successful companies started this way.

But if you want to reach the sky and compete with unicorns, change your question: not “what should I do if I am not one out of 100?” but “how do I become that one out of 100?” That is really why I started my Substack — to help founders like this.

QUESTION 9

If you were looking at two startups with similar upside, would you rather be early in the 10,000th AI company or early in the company trying to become the go-to choice in an overlooked category?

Neither. I would look at the founders and what they are trying to achieve and whether they can do it. Whether you are in the old space or new space is less relevant. Whatever you do, if it is cool enough, it will attract competition. Can you win that competitive game? That would be my first question.

QUESTION 10

A VC signals ”we have plenty of dry powder” but you suspect much of it is reserved, time-constrained, or encumbered by LP and follow-on obligations. How would you (a) analytically validate the effective deployable capital for your round and (b) strategically use what you learn to optimize valuation, terms, and syndicate construction?

A very important question. Established VCs always have reserves between 50 cents and $2 for each dollar they put to work initially into any company. However, it does not mean they will put it to work in your company.

Several practical pieces of advice: (1) Learn what this VC fund/firm/partner has done in the past for its portfolio companies, and in how many follow-on rounds it participated; (2) Learn about the other firms within their current portfolio — you are going to compete with them for follow-on money; (3) Always reserve allocation in your round for investors who may be able to invest or lead in the future. Be prepared to suffer higher dilution now to be able to secure funding later.

QUESTION 11

Deal mechanics and term sheets remain the least understood elements of the ecosystem, primarily due to their confidentiality. (Comment supporting deeper coverage of this topic.)

Not a question but a plea. And I answered it! Check my Substack, where I explain deal mechanics step by step from many angles using my Stanford VC class where we have been doing this for 12+ years (and more posts on that coming).

Unfortunately, too many founders concentrate only on a couple of provisions in the term sheets (valuation or a cap, vesting) and ignore so many others that will determine their success. Don’t make the same mistake.

QUESTION 12

What is one belief about venture investing that most LPs currently hold but that will prove wrong over the next five to ten years?

Many LPs tend to change their decisions very slowly. Once they invest in a fund manager, they tend to stay with that fund manager for quite a while. It might be a costly strategy, because the VC (and, more broadly, PE) industry is undergoing significant changes.

Take just one example: fund size. Successful fund managers tend to raise larger funds. In recent years, these fund sizes have jumped and often doubled, tripled, or quadrupled. Can the same fund manager deliver on a much larger fund? If the fund manager hires new partners, will the returns be the same? Can the strategy or fund thesis survive an exponential increase in fund size? I predict that many LPs will find the answer out the hard way.

I predict that there will be a large turnover in top fund managers over the next five years. I have just started producing VC rankings — and I expect we will have plenty of movement in the higher ranks. LPs that pay attention to these developments, are ready to back emerging fund managers, and adapt their capital allocation strategy are more likely to be successful.