Earning the Right to be Contrarian
When I first started investing in venture capital, I wanted to be contrarian. Badly. Being contrarian was a badge of honor (whereas pursuing consensus deals with lots of signals was “selling out”). Six years ago I even wrote this blog post that I now sorta agree with, sorta disagree with.
But the problem is if you have no signal, and the company you’re investing in has very little signal because it’s contrarian, you will need a mountain of positive data to change people’s minds/allow your portfolio companies to raise follow-on rounds.
It’s still doable, but it’s important to be realistic in a way I wasn’t always willing to be when we first started investing. I underestimated how much data would be necessary and how quickly that data would need to materialize. I idolized VC funds that took big, scary bets and won in the end. But I didn’t quite appreciate that they had earned the right to win in that way.
The best VC firms in the world take contrarian deals and turn them into consensus deals by funding them, and in return, applying their signal to their portfolio company.
A firm like USV can take a contrarian idea, and make it a consensus simply by having funded it. A lot of USV’s profit margin is not just in picking right, but by applying their signal to formerly contrarian companies that have since become consensus. And being consensus lower’s a company’s risk because it can more easily attract funding. This lower risk lowers the company’s discount rate and therefore increases the company’s value beyond just the dollars put into it.
First Round Capital was similar in that they were able to build a track record of leading rounds before founders of ideas were obvious. Since, they have been contrarian in how constrained they’ve kept their fund sizes, but their investments alone can turn a deal from being contrarian to consensus due to the signal they apply to deals.
But when our firm started, we had no signal. We weren’t well known, and yet we wanted to be contrarian. Bad combo. The problem is that our investment in contrarian companies didn’t give them any more signal than they had before – and so we relied on their data to make the deals consensus, not just our vote of confidence.
Many times we needed to be ready to keep funding the companies we backed until the data was as good as we needed it to be. This meant way more insider rounds than we anticipated. And a lot of bravery. Even when bravery wasn’t obvious.
Multiple times, we have had to raise SPVs to catalyze follow-on rounds of our highest conviction bets due to markets being more challenging for our best ideas compared to our expectations. And those SPVs are both risky (we had to raise LP capital to make concentrated bets, and in certain cases hold the bag on the subsequent rounds as well) and logistically complicated (the reporting involved, the time intensity of board seats in growth companies, etc). We often say internally that follow-on rounds are used for offense or defense (never in the middle). And when making contrarian bets, this is even more true.
Some of our most successful companies were ones that reached massive scale and still couldn’t raise money from brand name VCs. In our first fund, five of our first 25 deals ended up reaching nine-figure revenue run rates and profitability, many others raised large $25M+ equity financings, and yet the stories of their funding rounds were not as easy as the press has made them sound. Each of those rounds was an absolute grind filled with more no’s than we expected. Even in a hot market.
One of the painful lessons we learned was that “being right” didn’t mean “we would win”.
Sometimes, companies we backed that were doing very well never raised as much money as they needed to reach their full potential. They still did well, but it was harder than it should have been.
We’re proud of the portfolio and track record we’ve earned. We’ve also been luckier than I am letting on. But learning that being contrarian is an earned right, and not a birthright was a lesson we don’t take lightly.
The only way to earn the right to be contrarian is to have success. But how are you supposed to have success without being able to be contrarian? For new managers, there is a patch:
Raise a fund that’s small enough that you can sneak into high signal rounds with “follow-on checks” where you promise to work harder per dollar invested than the other VC funds are willing to do. This is worth doing because while you aren’t getting paid enough to do all the work you’re doing now, you’re investing in your reputation for tomorrow.
Invest in contrarian deals that have “short feedback loops.” And be prepared for the follow-on rounds to be hard. Publish content about the space those companies are in. Demonstrate the work you’ve done on the space publicly. So that by the time those companies pitch to follow-on investors you will at least have signal for the one space the company is in.
Firms early in their life have an advantage, that they are willing to do more work for less money because they are willing to do low-margin work now, for a bigger payoff later.
Once you have signal, you can do less obvious deals with longer feedback loops because of all the low-margin work you did in the first few funds, to earn the right to be contrarian later. To have earned the track record in those first funds to do so.
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