The "VC value trap" and how to do VC correctly
VC value trap
The “value trap” is what stock pickers call companies with valuation metrics and ratios that look underpriced but in actuality are traps that will lose you money. For example, a naive analyst may find a stock with a low P/E ratios, and assume its underpriced. More likely than not, the stock is fairly priced and you just don’t understand the full context of the stock: competitive pressure, earnings pressure, product failure, big investors bailing out, etc.
This same concept applies to private venture deals, but to an even more extreme as information is more tightly held and by definition "insider" as compared to public companies with reporting rules. I’ve made many private investments as both a personal angel as well as a professional fund manager with Anti Fund. VC value traps fall into two patterns:
Fallacy 1: You see something that others overlooked.
Fallacy 2: You uniquely can add value where others cannot, and you can be the one that changes the inflection of the business.
Fallacy #1:
Do you actually have unique perspective vs the market on an opportunity? Most likely you do not. The probability that you are super smart and smarter than everyone else who passed is low. On a more practical basis, if everyone else has already passed, the path to get co-investors or downstream investors to mark you up is that much harder.
Fallacy #2:
If you have the unique skill set to change the inflection of the business, you should probably consider controlling the business, not just investing in the business. Every early stage startup takes a lot of work. 90% of them fail by statistics. If you’re the one with the unique angle, then you might as well be the one compensated to control and engender the outcome.
Instead let’s look at patterns of when I made money.
Be Lazy-Smart
The very best investments I’ve made are made from the ethos of being “lazy smart.” It's actually hard to maintain the discipline of only making the obviously correct move and not over-intellectualizing and rationalizing sub-optimal investment decisions. The smartest and most ambitious people often make this error because they want to do things and make things happen. Instead you should be "lazy" and bucket your investment prospects into two buckets:
1. You would be a W-2 employee for the founders and the business.
In other words, if you had to find a job, would you dedicate 100% of your name and time into it? If it doesn't meet that high threshold, then why would you deploy your scarce investment capital in? Venture outcomes are power-law, so only the very top investments make all the money. I see most big VC firms lose their discipline here because they have too much AUM, need to deploy capital, and they hire a bunch of junior partners who are incentivized to be trigger-happy and often times don't stay long enough at the firm to see the actual exit and financial return (7+ years).
2. The company doesn't need you.
The very best companies will succeed with or without you. Venture capital game reverts into an access game. The average VC does not see the best deals, let alone even have a shot to beg themselves onto the cap table. This is the main reason wh laypeople and journalists sometimes criticize VCs as socialites, networkers, and bloviators. The layperson doesn't understand that VCs focusing on networking, conferences, brand, reputation, and marketing themselves as “founder friendly” is probably their best chance to horse-trade their way onto the best cap tables.
Conclusion
The criteria for VC investments is simple: only invest in companies you would personally work for, and only invest in companies that don’t need you to succeed. Getting your money in and staying disciplined to stick to this formula is the hard part. Don't be too smart and get caught in value traps. Instead, be lazy and have good vibes.