The ‘value add’ concept is nothing new, however it gained traction in the 1970s and 1980s as investors and founders alike began to realize that it’s not just about throwing money at promising startups; it’s critical that investors actively contribute to growth. Fast-forward to today, and the notion of ‘value-add’ investing has become so ubiquitous it’s simply assumed that venture capital allocators will lead with their ability to provide benefit far beyond the scope of the check they write.
And yet, maybe they don’t?
There are a couple of studies that we relied upon heavily in the ideation stage of In Revenue Capital (IRC), with the NewFund / University of Chicago research on ‘The VC-Founder Split’ being one of the most impactful. The results here fail to shock the senses having been involved in the capital space, first as a Limited Partner (LP) and now as a managing Partner at IRC – but 5 years ago, it seemed scathing – especially as the concept seemed to be getting so much positive lip service.
This was also around the time that a number of early-stage funds began to emerge touting an even deeper commitment to value beyond the cap table, and what’s more they were focusing on an element of business that I believe to be the only true ‘moat’ for the majority of startups, go-to-market (GTM) strategy and execution. These aren’t the unicorns out building rockets to populate Mars, turning water into wine, or other earth-shattering innovations. Instead, most B2B SaaS businesses have competition, often a lot of it, and rather than product innovations that are orders of magnitude above all others, they have a handful of features that are differentiated, a vertical focus, or have wielded perception in their favor. This is simply the reality for most organizations. Therefore, if they cannot rely on being the only kid on the block, they must out execute their neighbors – and GTM excellence, in my opinion, is squarely the path to do so.
So, when these renegade firms arose, touting what is now called ‘Operator Capital,’ they were based on the model that all fund investors would be experts. Those experts could in turn provide the coveted ‘value’ that all founders seek, all VC firms promise, but (as shown in the faithful NewFund study) seems to be little more than lip service in reality. The rise of ‘operator capital’ seemed to be a soothing balm to the open wound founders were nursing to that point without aid. I was all in as an investor under this new and shiny model. It was also a great way to get exposure into a realm that I had earmarked as my future, while applying my almost three decades of GTM knowledge as a founder and operator.
What I found was, suffice it to say, not what I was expecting.
Before I get into the ‘why’ behind this disappointment, it’s important to briefly highlight what was happening in tandem to this. Studies are great, and the aforementioned report gave us enough positive validation to dive deeper, but we knew we needed real-world insight. That’s exactly what we did, as we began speaking to any founder, early exec team member, or VC that would pick up the phone or let us in the door. To our surprise, almost everyone we approached for feedback, was happy to provide it. What wasn’t surprising was the feedback gathered, was also strangely aligned in some ways. When VCs spoke about value-add, they predominately went to areas of introduction and advisory. The primary value most VCs centered on was opening doors to subsequent funding sources – which makes sense. VCs want big markups on their investments so early-stage venture firms cultivate strong relationships with capital allocators that focus on subsequent funding rounds – it’s squarely in their best interest – and most times also in the interest of the portfolio company. The same held true for large corporate relationships VCs open the doors to – that’s an easy way to potentially bolster the revenue lines of their investment. Over and over, we found that low effort, large profile activities were the focus of ‘value-add’ VCs.
However, when we spoke to founders, they spent most of their time at a much lower altitude. They were in the weeds, and even though they could turn to their VC partners for big headline introductions or advisory, their biggest challenge was the ticking and tying necessary to connect those big headlines to bottom-line results via the latticework of execution. There was a big gap here, and frankly not one that VCs were anxious to solve for. After all, they view that the founder and their teams are responsible for getting down in the mud and making it work – that’s why they invested in them in the first place.
This brings us back to ‘Operator Capital’ – which I perceived to be designed around solving this problem. As mentioned, I’m an LP in what is the most prominent of these funds, so I’ve had a front row seat to their approach and evolution.
My two big takeaways as to why Operator Capital and to a much larger extent, ‘value-add investing’ as a whole, is an illusion:
1. Wealth and Work are negatively correlated: I’m talking real ‘in the weeds’ type of work here. The more money you have, the less time you want to spend truly executing (on the whole). It’s ok, we can say it out loud. This is just the predominant state. As individuals and firms acquire more wealth, they naturally want to focus on big windfall activities – this is exactly what we see as self-admitted amongst capital allocators. The problem of course is that the majority of startups fail due to an inability to execute and therefore they types of ‘value’ provision that VCs gravitate toward simply doesn’t serve the most acute pain.
Ok, so ‘Operator Capital’ should solve for that right?
2. Fund Dynamics are the death of focus: What the hell is a fund dynamic? For this intent let’s describe it as all of the financial and logistical complexity which is bred from Venture Capital’s reliance on what is termed ‘Power Law.’ Power Law in relation to venture investing states that one single investment will yield larger returns than all other investments in the fund, often by orders of magnitude. We call these ‘home runs.’ From a ratio perspective, a typical fund will yield eight strikeouts, one single or double and then a home run. I’m using those figures illustratively; typical VC funds deploy far more than 10 investments per fund. What the hell does this have to do with ‘operator capital’? Herrin lies the rub. Current operators, most often, do not have the type of free capital necessary to make a big dent in a 100MM+ fund. So, we need a LOT of them. And then even when you have gathered enough of them to comprise a sizable fund, the returns from those investments are measured on a loooong horizon – especially when the end game is 1B+ valuations and eight or nine figure exits. So, we need to find more operator LPs, as the LPs in Fund 1 have a low probability of participating in Fund 2. But, we need to keep collecting and deploying capital to garner the management fees that those funds kickoff (which pay the firms salaries) and to garner the type of scale necessary to ensure Power Law is applicable.
In short, you need to spread a lot of money around in a lot of different companies to leverage the odds – after all, 82% of all startups fail. What’s the bottom line to all of this? Operator Capital requires a LOT of LPs. More than 350 LPs (which is a fair median within these funds) are untenable to manage in an effective way – a way that benefits the startup. To apply best practices, meaningful advisory and tactical assistance, you really need to have an intimate relationship with a startup as well as the LPs who can help.
Where does this leave us?
We’ve all heard the famous Einstein misquote, that doing the same thing repeatedly but expecting different results, is insanity (proper attribution to Rita Mae Brown). That quote applies well here. Listen, sometimes founders just want money – they may articulate otherwise, and they would be wrong to simply chase the check – but that segment certainly exists. Let’s assume you’re one of the others, a founder who truly wants investors on the cap table who bring far more than deep pockets. In that case, it’s critical to look for those doing things fundamentally different.
First, they need to love tactics – or have dedicated resources within the firm who do. And those resources must have a real-world track record of success in their chosen discipline. And it has to be recent – not 20 years ago. If someone has been out of the game for a decade and they are telling you they’d love to get back in, they’re lying. We do what we love, and we don’t stop doing it due to financial success.
Finally, their firm structure needs to allow for focus. If they are beholden to the same old numbers game, you’re going to become a number. This is why I truly love the Fundless Sponsor model (more on that here) and the freedom it allows – not only for the firm and our LPs but more importantly, for founders in our portfolio. Because I don’t have to deploy capital, I do so only when the fit is 100% right, for all parties, which is predominately defined by our ability to truly deploy our GTM value-add.
Yes, this model is new. Yes, I’m preaching against a business model that is as old as time. But, it’s also a model with historic odds so poor that even the most degenerate of gamblers would wince and call ‘uncle’ – so that alone tells me it’s overdue for change.
Founders’ cross deserts everyday as they lead their teams to build something out of nothing; they deserve more than a mouthful of sand upon diving into the seeming oasis described as ‘value-add.’ True expertise and operational assistance doesn’t need to be an illusion – you just need to look beyond the same old places.
