How new VC funds can win by differentiation in the UK
Outperforming the competition in startup investment is hard. Doing it as a new fund, without the name, is really hard. One of the reasons…
Outperforming the competition in startup investment is hard. Doing it as a new fund, without the name, is really hard. One of the reasons for this, as far as I’m concerned, is that funds fail to differentiate. Almost everyone’s pitch is the same — “we have great ex-entrepreneurs. We’ll use our experience to help you on the entrepreneur journey”, or some variant thereof. New funds struggle to compete with this, because they simply don’t offer differentiation from this well-known pitch, and therefore (most often) lose against a fund with a name, and a track record.
What are the options for a new fund, and how can they build a winning strategy through differentiation?
One thing that funds could do is offer different terms to LPs — e.g. different IRR/ Liquidity/ Risk expectations — and token-focused VCs obviously have greater flexibility here. But putting that to one side, given the traditional 2/2.5 and 20 VC model, how does a new fund achieve superior performance — in busy VC markets?
To start with the basics: getting a good return on money invested means either investing in good companies, and/ or investing in bad companies, and making them better. While funds can definitely have an impact on their investments, it seems to be broadly accepted that the more important factor in a winning portfolio is simply investing in good companies — so that’s what we will focus on here.
So the key to a good portfolio is: “how do I invest in good companies” — how do I participate in the most promising deals?
There are broadly two ways to do this (and obviously shades of grey in between):
1. You invest in companies that have unrecognised value, which the market (i.e. competition) is overlooking
2. You manage to win deals in the companies that the market thinks are a good use of capital.
Investing in companies that have unrecognised value
Seeing value in companies that the broader market have overlooked is the type of principle that many VCs claim to follow, but fail to practise. Put simply, despite many VCs and CVCs claiming they are contrarian, in reality, there is often a herd mentality, with “if they’re in, we’re in” often frustrating founders. For those who are really keen to win through identifying value where others have no interest, there are two things you could focus on:
a. Overcome biases that others have. It is well known that the overwhelming majority of founders in any portfolio are depressingly similar — they look (gender, ethnicity, origin etc) and sound (background, demographic etc) the same, and therefore have very similar cognitive biases. Funds that have a relentless focus on identifying value in more diverse contexts have therefore seen great portfolio value as a result. That’s (one of many reasons) why Backstage Capital in the US are so interesting.
b. Focus on developing knowledge in an area that allows you to identify value where others cannot — so you can genuinely be “contrarian”. Everyone says they are being contrarian, very few actually are, and this might partially be because being contrarian without being well informed is not well advised. Instead, funds that commit serious resource to knowing more than anyone else about a sector that is underserved by capital — these guys can be well-informed and contrarian. Great example of this is Lightspeed Ventures in the US. How many funds know enough about FMCG to target Vertically Integrated retailers? Not many.
Winning the deals that everyone wants
An easy answer here is “if you have the name, you’ll win the deal”, and everyone knows the virtuous circle that this produces (good deal, good name, good deal and so on). But we’re interested in how new funds can win by differentiation, which means no name, and no circle.
The key question is — how can a new fund incentivise a startup to take their money, instead of BIG-Established-Fund money. Again, I see two broad categories of incentive here:
a. You pay the founder to take your money. One way to do this, is to offer portfolio founders carry on the fund. This idea is genius, as it offers a founder a bit of risk diversification — given the high risk of their startup failing. Kindred Capital, one of the most disruptive VCs in the UK, are doing this. They also highlight that this gives founders an incentive to support the rest of the portfolio — another genius element of this model. Alternatively, a fund can simply “pay” the founder by undercutting other funds, with a flattering valuation, or through really, really beneficial terms — but this pricing competition isn’t so innovative or exciting, and it implies that your only value-add as a VC is your money, not your experience or advice..
b. You offer a genuinely distinctive service to the startup. As set out above, the majority of UK VCs offer very little differentiation.* They offer a range of support across the entrepreneur’s journey (sessions on marketing, Biz Dev, leadership etc), and have heaps of entrepreneurial experience, but so does everyone else.
What distinctive service could VCs provide? As with all product development, if we treat the additional services like a product sold to the entrepreneur, the key questions to identify and prioritise these services should be: What do entrepreneurs need to do to succeed? Where are the pain points that entrepreneurs will encounter in doing so? What solutions can we provide to reduce or eliminate those pain points?
If a VC’s product genuinely solves a significant pain for the founder, in a way that a more generalist fund cannot, — then that is real differentiation. In general, this type of differentiation just doesn’t seem to have hit the UK market yet, but there is some really interesting differentiation done in this space in the US, such as:
1. Recruitment-focused VC. Finding the right talent is a massive challenge for entrepreneurs — founders often say that they spend 50% of their time, minimum, recruiting for their team, at least early on. Building a team is obviously a crucial part of building culture, so outsourcing this entirely is probably not wise. However, a fund which uses its recruitment prowess/ reputation, as well as talent network, as a differentiator, would surely be a value add. Crucially, specialist recruiters are a capability that you generally won’t get from your other VCs (although there may well be some form of talent support), and can’t (yet) afford to buy. The question is: are you willing to sub out one of your big, undifferentiated funds, for the specialist service?
2. CVC, when done well, can also offer this differentiation. Taking money from a CVC may not offer the same broad entrepreneurial support as a standard VC, but it can be a springboard to early traction, if done right. This can be a huge pain-point for startups, especially in the enterprise space. The corporate, once invested, is strongly incentivised to make stuff happen with the startup internally. VCs, while obviously being incentivised to make introductions and drive traction, don’t have the mix of appetite and ability that a corporate sponsor has to make traction actually happen. Whoever the corporate sponsor of the deal was — it’s often their responsibility to make it create value for the company, and this pressure can be a shortcut to decent traction for the startup.
3. While not strictly a fund, companies like Sandwich Video, which make high-end marketing videos, and can be paid with equity, are an interesting take on a fund. Again, you won’t be able to afford to buy the videos as a startup, but they can add serious early value to your company — and again, an established VC won’t be providing this.
4. A policy / regulation-centred fund, focusing on the most heavily regulated markets that startups can target — think healthtech, fintech, infrastructure (e.g. energy) — where policy can make or kill your startup. Again, undifferentiated funds are likely to say they offer some of this, along with all other services, but by the nature of a “we do everything” fund, this will simply not provide the coverage and depth that a specialist policy fund could provide. What pains could this cure? To start, the fund could be:
a. Extremely well informed about the current and future policy landscape — and how startups can use it to disrupt markets and scale quicker.
b. Networked across the policy scene, in order to influence how brand new markets develop — in areas like AI, policy frameworks will have to be created hand-in-hand with companies and investors producing and exploiting technology.
c. Able to identify the one-off policy or regulatory risks that might derail the business.
Policy value-add need not be rivalrous with more generic funds. With startups such as Babylon (healthtech), Biomitech (energy), or even Uber (taxi market) — the simple question is — would they have substituted out just one of several “do everything” funds, for a fund that can guide them through all the pitfalls and opportunities of policy in their market?
A clear strategy, by necessity
So there are options to differentiate as a new fund, and to get into the deals that will create a top portfolio — both by uncovering deals that others have overlooked, and by winning the deals that everyone else is after. Crucially, being clear about how you are differentiating will tell LPs, and prospective portfolio companies, that you have a strategy to win.
*On a side note, a further challenge for funds seeking to differentiate is not just to claim that they have a distinctive value-add, but to credential that claim. This can be difficult because in VC, promises are often subjective and intangible (e.g. connections, advice etc), and partially because of the long feedback loop, which means that new funds struggle to get the key testimonials that deliver this credibility. Funds seeking to differentiate therefore have much the same challenge as founders — not just convincing their backers that they are differentiated in theory, but that they can deliver on this differentiation in practice.
Thanks to Alex Dunsdon, Leo Ringer, Taha El Hajji and Joel Bowman, who all gave valuable feedback to earlier drafts of this piece.