Conviction Investing

Conviction, n., a strong persuasion or belief.

Many early-stage seed investors and venture capitalists invest alongside one another as part of investment syndicates.

Investment syndicates exist for good reason. Most investors at this stage don’t control large amounts of capital, many of them are individuals or angel investors, and so they’re unable to fund the capital needs of a company on their own. By pooling capital with other investors, companies are seed funded with $500k or more. Syndicates also increase access to information. Many investors will tell one another about the amazing companies and entrepreneurs they find. On balance, access to larger pools of capital and more transparent information exchange are positives for entrepreneurs. AngelList is the best example right now of the benefits of investment syndicates at scale.

But investment syndicates can also have dangerous side effects for entrepreneurs—collateral damage so to speak. These effects have been widely documented, mainly as it relates to particular forms of information exchange amongst investors in a still largely opaque market. When VCs exchange information about potential investments, they sometimes share thoughts regarding company valuation. In most markets, this might be anti-competitive behavior. In early-stage private company technology markets, it’s at best unethical.

But there’s also a negative side effect of investment syndicates for investors. In any market, investors will often discuss the merits of an investment with one another, especially through the diligence process. But in a market as tightly knit as seed-stage Internet technology, the effects of information exchange are amplified as investors try to pull syndicates together in order to complete an investment round. The reason this is negative for investors is that this can lead to investment decisions based on social proof rather than conviction. In fact, if you’re an entrepreneur, you’ve almost certainly heard investor questions grasping for social proof:

“Who else are you meeting with?”
“So this is kind of like what company x is doing for y market?”

These questions are no better for investors as they are bad for entrepreneurs - investing with the herd is a notoriously bad strategy that leads to poor returns in any market. In the early-stage technology market, Fred Wilson and Bill Gurley have both written nice posts on the subject.

Investing in early-stage companies with conviction is really (really) difficult. There are very few lines to connect the dots. However, there are a select few people who do it really well. I’ve begun to call these people conviction investors. By definition, they’re a rare breed, which is a shame, because I’ve often found they’re the most helpful investors for entrepreneurs.

Why is investing with conviction so difficult?

For starters, it’s simply not easy to tell another fellow investor, a friend, maybe even someone you respect deeply (and believe is good at what they do), that they’re wrong. What if John Doerr came to you with what he believed was an amazing investment opportunity? How might you feel if an entrepreneur explains that her round is oversubscribed, investors you know and respect are committed, and that she might be able to find a little room to squeeze you in? Could you look at these opportunities and entrepreneurs without positive bias? True conviction investors have strong opinions; they’re looking for specific innovations and special people, and they’re willing to take a stand and write a check when others waver. They’re not hoping to invest because their friends or colleagues are doing it. In fact, this type of investor loves it when other investors “don’t get it.”

Conviction investing also requires emotional self-management. Venture capital, by design, is an unnatural form of investing. Explain to a normal person that 50% of the companies you invest in will go bankrupt. This is stomach-churning. I believe there’s a tendency amongst early-stage investors to balance this unnatural investment strategy with the more natural behavior of investing alongside friends and colleagues. Unfortunately, more often than not, this is the wrong strategy.

A contrarian strategy, even if theoretically correct, can be particularly difficult for young investors with little or no track record (myself included). The reason for this is because time horizons in the venture capital industry are long, often five or more years before you see any real results or validation. So if you’re doing it right, many of your peers, mentors and managers will call you crazy (or let you go) before you can tell them “I told you so.” I believe this is one of the reasons why structurally it’s so difficult to build a career in venture capital.

I can’t claim I’m a conviction investor yet, but I think I know now where the goal is, and I fight almost daily (with my own emotional state) to get there. Between meeting new entrepreneurs and phone calls with investors and Techcrunch and VC blogs and Internet trend forecasts and “this person made that investment,” it can be incredibly difficult to block out the noise. Conviction investing requires a certain degree of crazy, some of it learned over time and some of it innate. It’s the same sort of crazy seen in the best entrepreneurs and companies. For now, while I’m still learning, I’ve removed “who else is investing” from my vocabulary.


Now read this

On Negotiating Valuations…

…and the impact of VC portfolio construction on startups. Since starting Notation Capital earlier this year, we’ve led (or co-led) 8 pre-seed rounds in new companies. Each investment involved at least some amount of negotiation, often... Continue →