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Contrary to common belief, 2008’s global financial crisis (GFC) did not significantly change the venture industry like it changed the rest of the financial services. Most funds that continued to invest through the GFC did so in already commercially profitable companies. Since then, investor risk appetite to venture has only grown, but now the industry faces a second crisis wave — that of valuations, an urgent need to fix the lack of transparency, and the need for a truly systemic approach.
The next generation of investors has different priorities and requirements than their predecessors and is set to change the venture landscape, just as their retail counterparts did to stock exchanges at the end of the 20th century.
Only four decades ago, trading on stock markets was the playground of Ivy League alumni. Stock exchanges were closed spaces to the general public, but technology-enabled transparency ushered in a wave of desperately needed democratization. This wave is now reaching the shores of venture through the proliferation of crowdfunding platforms and the rise of data-driven funds.
It was already challenging as a founder to create and commercialize an idea in previous market conditions — much less operate in today’s declining, inflationary post-COVID market. How can we better prepare founders to ride these new waves of investment shifts?
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A data-driven approach
The likelihood of successfully raising capital will be significantly challenged by funds moving towards a more data-driven investment philosophy. The near future could very well include machine-driven credit-like scoring for startups to filter the “no” answers and spend more internal resources on due diligence for “yes” answers.
For the data-driven investment approach to really take hold in venture, greater standardization of and transparency around the metrics that founders provide to venture capital (VC) funds is critical. This is difficult — especially in the early stages where data is scarce. The ultimate goal is to make it next to impossible to misrepresent data, as when founders manipulate users’ lifetime value or accounting information to paint a rosier view. Based on these upcoming shifts, several new best practices will emerge:
1. No data — no capital
Without accessible information and a history of founding teams, founders will struggle to raise funds. Gone are the days of remaining out of the public eye. So, start developing the public profile of the founder(s) and the company from early on. Be sure that the information is in the public space and that the investment deck is consistent.
2. More diverse founding teams
More diverse founding teams will drive higher scores by VC funds. Founders must embed this in their startups’ DNA, not include this as an afterthought or PR exercise. Diversity of team members and their cultural views will likely enable access to and innovation in new markets.
More diverse teams will also make their business more sustainable. The people who pay for products and services are all very different; therefore, the team creating the product or service should have wider horizons. The more diverse the team, the more successful the business is positioned to be. Despite occasional difficulties in building communication between people with different backgrounds and identities, developing a diverse team from the beginning pays greater employee, partner and customer cohesion and satisfaction dividends down the track.
Founders should hire people who differ from themselves as much as possible while sharing the common values of service, excellence, imagination, creativity, loyalty and balance.
While at the surface level, it appears fundraising will become more cumbersome in a data-driven model, the benefits it can bring to startup selection will outweigh initial growing pains in the long term.
Underrepresented founders and more technically challenging ideas will have a more level playing field for fundraising. Founder charisma, an articulate pitch and a strong marketing budget will always play roles, but they won’t be sufficient to beat an algorithm.
A standardized investment score algorithm doesn’t care how good your pitch is because it primarily looks at the facts, market data, founder track record and more than 100 other data points. The loudness of a founder’s voice and being very confident won’t count for much in an algorithm’s calculations.
A data-driven approach gives deserved advantages to founders who previously might have been overlooked. Deep-tech startups and products for niche B2B markets will become more comprehensible and more funded with the expectation that they will become more profitable.
As the venture industry becomes transparent, startups will get benchmarks that are critical during periods of uncertainty. Suddenly, investors might find that metrics that previously seemed substandard now have much higher than average value in the market due to a new appreciation for better data.
The industry should be vigilant to prevent algorithms from inheriting human bias and prejudices and make sure to continue to use human judgment on top of the algorithm. In the near future, it’s this hybrid model that will prevail.
The new magic of VC
While change can be uncomfortable, it’s better to go through discomfort rather than risk being left behind and being disrupted by someone else. Let’s have more public debate about data-driven approaches because they help us find win-win-win solutions that help investors, founders and the end users who will be the ultimate beneficiaries of start-up innovations.
The “black magic of VC” needs to change in order to build a thriving culture that benefits from a diverse workforce. Finally, the objective and ethical use of data will facilitate transparency and accountability to build trust with investors, founders and potential partners to create a more robust VC asset class.
Alan Vaksman is founding partner of Digital Horizon and cofounder of Launchbay VC Investment Platform.
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