In Search of Alpha
If you’ve spent any time reading “VC Twitter” or been in the company of a group of VCs for more than 5 minutes, you’ve probably seen or heard reference to the concept of “finding alpha”. But what is “alpha” and where do you find it?
Alpha is one of the key metrics used to evaluate the performance of an investment portfolio. It measures a portfolio manager’s ability to outperform a market index, when adjusted for risk. An alpha of 1.0 means that the investment outperformed its benchmark index by 1%.
Of course, most VCs aren’t actually thinking about rigorous financial benchmarking when they’re talking about alpha.
When VCs talk about “finding alpha,” they’re loosely referring to the strategies they use to (a) win deals and (b) increase the likelihood that the startups they invest in succeed.
Hunting vs. Farming
The “hunter / farmer” sales model is one that’s been around for decades and captures these two key aspects of venture capital. In this methodology, “hunters” are salespeople who seek out and win new customers, while “farmers” cultivate relationships and generate returns from existing customers.
In venture capital, “hunting” refers to going out and winning new deals (investing in new companies) while “farming” refers to increasing the likelihood that a company will succeed through post-investment support and services.
Hunting Alpha
It goes without saying that VCs must first-and-foremost invest in startups. But what does alpha refer to in this context?
When VCs think about generating returns through hunting, they’re referring to two things:
Being able to invest in the best companies they can (winning deals)
Being able to invest at the best price they can (maximizing the potential return on an investment)
In both cases, investors can increase their chances of success by identifying and investing in startups early. Stated differently, when VCs are talking about “hunting alpha”, what they’re really referring to is avoiding competition.
For any given startup, one of the primary drivers of valuation is the level of competition amongst investors. This is why high-velocity fundraising is typically the best approach for early-stage startups. Investors, however, want to minimize competition. Not only does competition reduce the likelihood that a firm will win a deal (point 1 above), but if it does, the price will likely be higher (point 2 above).
Within VC firms, “deal sourcing” refers to the activities that the VC performs in order to identify new startups. Like any organization that performs sales and marketing, deal sourcing for VCs is a combination of “inbound” and “outbound” activities.
Inbound activities focus on increasing the likelihood that founders will reach out to the firm when they fundraise. These include traditional marketing activities like public speaking, newsletters and blogging (like the post you’re reading right now 😉).
Outbound activities try to proactively identify startups before they fundraise, in order to give the VC an opportunity to engage with the founders early. If you’ve ever received cold emails from VCs asking to meet, this is what I’m talking about.
For early-stage VCs, outbound activities focus on identifying both startups that might be of interest and individuals who might become founders.
In the US, most startups incorporate as Delaware C-Corps. The Delaware Division of Corporations has a public database of all registered companies and many VCs have built bots that monitor that registry for new companies that might be of interest. LinkedIn is another source of potential leads for VCs. If you’ve ever changed your status to “Starting Something New” or “Cofounder at Stealth”, VCs around the world immediately know.
Many VCs also have outbound activities that are designed to systematically leverage their networks to identify potential investments. Scout programs, in which VC firms empower founders and others in their network to make small investments on their behalf, are an example of this. The original scout program was created by Sequoia more than 10 years ago and led to early investments in Uber and Stripe.
Farming Alpha
In venture capital, “farming” refers to all of the ways VCs try to increase the likelihood that the startups they invest in succeed. Historically, this started and ended with the investing partner. After making a new investment, the lead partner might regularly meet with the founders to give them advice, sit on their board to provide fiduciary oversight, make introductions, etc. But that was about it.
In the early 2000s, VC firms started to build internal capabilities to perform some of the key but non-core functions startups required. The premise was that by helping founders not “get distracted” by non-core activities, they could increase the velocity of the startup and the likelihood that it would succeed.
After DataHero closed its Pre-Seed round in 2012, my cofounder and I easily spent two months on non-core activities, ranging from setting up bank accounts and accounting systems to building recruiting and onboarding infrastructure to generating legal agreements.
First Round Capital was one of the first firms to do this at scale, providing the startups it invested in with accounting and other services needed to “stand up” a company. Today, many VCs employ subject matter experts (such as internal recruiters, design partners and even decision support partners) that their portfolio companies can leverage. a16z famously employs more operating partners than it does investing partners.
At Panache Ventures, one of the ways we generate farming alpha is through Panache Academy, our San Francisco-based accelerator. Panache Academy delivers programs exclusive to our portfolio companies, such as our quarterly fundraising bootcamp. We believe (and have the data to show) that participating in the Panache Academy fundraising bootcamp materially increases the likelihood that our portfolio companies will succeed in raising follow-on capital, the valuation at which they raise follow-on capital, and the quality of the VC firms from which they raise follow-on capital (all of which increase the likelihood that those companies will succeed).
In fact, the entire accelerator model is based on a farming-centric approach to generating returns. Prominent accelerators like Y Combinator, Techstars and 500 Startups all have models built on investing in a large numbers of very early startups and surrounding them with the expertise needed to help them get to product-market fit.
The level of competition amongst VCs has never been higher. At the same time, outbound activities are becoming commoditized, greatly diminishing the potential for hunting alpha.
As we look ahead to the next decade of venture, I believe that the importance of investor value-add — farming — will only magnify in importance. Even in the current downturn, founders are firmly in the drivers seat when it comes to choosing who to allow on their cap table. Providing more than just capital is now table stakes for VCs and where the next decade of alpha is like to come from.