Deal Flow Is Dead, Long Live Thesis Driven Investing

“Deal flow” has long been regarded as the lifeblood of venture capital and the primary point of competitive differentiation between venture firms.   To this end, it’s not uncommon to hear venture firms publicly boast about this or that proprietary source of deal flow or to hear limited partners studiously inquire about which firm has the highest quality deal flow.  While deal flow undoubtedly remains an important part of venture capital, changes in the venture industry are making deal flow far less important and rapidly making deal flow-centric business models unsustainable for all but a few venture firms.

Build It And They Will Come
At its heart, the deal flow-centric view of venture world is premised on a passive approach to venture investing that essentially subscribes to a “build it and they will come” theory of venture investing.  To grossly, but not inaccurately, simplify this view: all it takes to have a successful venture firm is to open an office on Sand Hill Road, stock the office with well known/connected former operators/financiers, wait for the entrepreneurs to come flocking to your door and then simply invest in the best teams with the best ideas.

It’s as if Venture Capitalists were Grizzly Bears: Just stake out a good position in the middle of the best salmon run, watch the fish go by, and occasionally swat the best looking fish out of the air.  In this model VCs are cast as true renaissance men, capable of doing a communications equipment deal one day and an alternative energy deal the next.  They have no need to be experts in specific industries but instead pass judgment on the quality and pedigree of start-up teams with the belief that their connections and experience can help get any company off the ground.

This flow-centric business model made a tremendous amount of sense when the venture industry was relatively small and immature.  Back then, there were only a handful of competitors and funds were relatively modest in size.  For example, in 1980 there were only 183 venture capital firms and each firm had an average of only $41.6M under management.  Given this, as well as the immaturity of venture capital as an asset class in 1980, it’s probably safe to say that venture capital in 1980 was a true “buyer’s market” with more demand for capital than supply.   Perhaps more importantly, the investable landscape for venture capital, particularly technology venture capital, was both “thin” and “shallow”.  It was “thin” in that there were only a few sectors one could invest in.  It was “shallow” in that each sector was quite small and often only composed of a few companies.

In this context, a passive deal flow-oriented business model made a tremendous amount of sense.  Not only was there more than enough deals to go around, but the chances of seeing any given deal prior to funding were quite high.  In addition, it did not make sense to develop expertise in specific domain areas because there simply weren’t enough new deals in a given space to justify such a concentration.

It’s Not Your Father’s Venture Capital Anymore
Fast forward 20 years and the world has changed dramatically.  There are now over 3,300 venture firms managing an average of $280M each with a total of $265BN in capital under management.   What’s more, the investable venture landscape is vastly larger and more intricate; it is now both wide and deep.  Using the NASDAQ’s market capitalization as a proxy, the investable market has expanded by a full order of magnitude in just the last 15 years.  Areas of the market that didn’t exist to any substantial extent 15 or 20 years ago, such as the internet, information security, and networking, are now large enough to easily produce enough quality deals to not only gainfully employ the full productive efforts of a single partner, but of even an entire firm. 

To go back to the Grizzly bears, it’s as if the population of bears on the river has increased by almost 20X and not only are there now lots of bears both upstream and downstream, but there are lots of bears specializing in particular types of fish.   The only thing that is flowing by the average bear is unwanted leftovers from someone else’s catch.

For all but a few firms, the dramatic increase in the scope, complexity and competitive intensity of the venture business makes a deal flow-based business model, no matter how good one’s networks or connections, unsustainable because the risk of adverse selection has become so great and in those rare circumstances that a good deal actually makes it into the public domain, intense competition is likely to drive pricing up to a point where the good deal becomes bad because it's just too expensive.  Net, net the cold reality is that the venture business is now clearly and permanently a seller’s market.

Exceptions To the Rule
That said, there are probably two classes of firms that can still get by with a deal-flow oriented operating model including:

1. The Best of The Best:  There are a few firms that have been in business so long and have been so successful that they can sustain a deal-flow based operating model.    They have a large amount of very high-quality incoming deal flow and even when they find themselves in a competitive situation their reputation usually enables them to win the deal.  This is not the top quartile of venture funds (825) or even the top decline (330), it is just a handful of firms that have such presence and brand that they can rise above the fray.  Even though they are capable of sustaining a deal flow based operating model, many of them won’t because they realize that they simply don’t have the scope necessary to see every deal worth doing.
2. Big Fish in Small Ponds:  70% of the venture capital under management in the US in concentrated in just three states: California, New York, and Massachusetts.  Outside of these three areas, local venture capital is often hard to come by and the market looks much more like the “thin and shallow” national market of 1980.  VCs in regional markets with very strong local reputations can be reasonably confident that they will see pretty much every deal worth seeing in their area and every entrepreneur in the area knows that these are the “go to” firms.  For example, my former partner Brad Feld (who has a great blog of his own) is “Da Man” in Boulder Colorado and there’s probably not a deal in the Boulder/Denver area that he doesn’t get to see.   If Brad wanted to, he could probably just sit back and wait for deals to come to him all day (he doesn't) and still have a viable business.

The Party’s Over
For the rest of the industry, deal-flow based business models are now unsustainable thanks to two simple facts: 1. The venture industry simply is too big and too competitive for any firm to sit back wait for deals to come to them.  2. There is so much money in the industry now that any firm that is waiting for “hot” deal flow will likely find itself in the midst of a ruinous bidding war.

A favorite example of this situation is the social networking space.  The poster child of that space, Friendster, generated a true frenzy amongst VCs.  Friendster ultimately was invested in by two top-tier VCs but those VCs paid dearly for the honor, despite their brands, thanks the “seller’s market” that exists for hot VC deals in markets with an abundant capital.

Thesis Driven Investing
In such a competitive and complex environment the most promising way for VCs to ensure themselves of rising above the tide is to move from a passive deal-flow based approach to a proactive thesis driven investment approach.  This approach stresses taking the initiative to develop an investment thesis based on focused expertise and then using that investment thesis as the basis for a directed deal acquisition campaign designed to either ferret out those existing start-ups that fit into this investment thesis or to help create new companies that can take advantage of an identified opportunity.

In this model, VCs do not passively sit back and let deals come to them, but they go and out and “turn over rocks” actively looking for deals that fit their investment thesis in a particular space.    VCs, even ones with no brands and experience, can compete with this strategy due to two simple facts:  1. Entrepreneurs respect VCs that understand their market space/business. 2.  Entrepreneurs rarely refuse to talk with VCs that proactively call them and tell them that they are potentially interested in investing in their business.  The goal is not to wait for companies to come and ask for money, but to find good companies in good spaces and then try to find a way to put money into them when appropriate.

Pick Your Poison
Many GPs and LPs believe such thesis-driven investing to be more risky than traditional deal-flow driven investing because it requires firms to make two bets instead of just one in that firms must first bet on a general thesis and then bet on a company that matches that thesis.  This means that if the thesis is wrong, a whole crop of investments could turn out poorly.    From this perspective, why take the risk of getting the first part wrong?

The problem with this criticism is that it pre-supposes that the old deal-flow based approach remains viable.  This pre-supposition may have been valid 20 years ago but it is now no longer valid thanks to the huge risks that deal-flow based business models face in terms of scope management, adverse selection and competitive pricing.   The belief that deal-flow remains king in VC is therefore a dangerously outdated perspective on the venture industry that is no longer relevant for all but a handful of firms.

Retooling Required
For Venture Capital firms, the industry’s shift from deal-flow to thesis driven investing has many practical implications.  First, firms must place greater emphasis on developing investment theses and proactively calling on companies as opposed to developing networks of deal-flow relationships.  That’s not to say that deal-flow relationships will become unimportant, just that they are now relatively less important.  Firms must also become more specialized, either at the firm or partner level, so that they can develop the industry insight and expertise necessary to exploit investment theses within specific sectors.   Finally, firms may have to adopt a more systematized and professional process for not only developing investment theses but for executing on those theses once developed.

Making these changes won’t guarantee investment success but they will enable firms to compete effectively in a highly competitive venture capital market that is dramatically different from the market of 20 and even 10 years ago.