[No. 2.0] Dimensions of Evaluation

A mental model for evaluating VC funds

Sorry for the delay folks. The good news is that I have a backlog of drafts that should last a couple of weeks... so stay tuned! Also, be sure to follow on Twitter @ckthoms as I may not email future posts.

This post is titled [No. 2.0] because I plan to reference this framework in future posts and use it as a roadmap. My sense is this could also be useful to emerging managers who are putting together their overall narrative. Again, part of the goal of writing publicly is to crystallize my own thinking and get feedback so if you have any comments or questions please let me know.

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Evaluation Framework

At the highest level, there are six dimensions of evaluation that I use as part of my framework for investing in venture managers:

I first started thinking about this framework and graphic after reading a post from Tribe Capital, “A Quantitative Approach to Product Market Fit.” If you haven’t read their post it is absolutely worth a read. I’ve always thought there are similarities between early-stage investing and fund investing and will probably cover this in a future post. For instance, I often hear early-stage GPs discuss whether they are a team or market-driven investor. LPs often think of a similar dynamic between team and strategy. You will find LPs that are willing to bet on an individual or team while others focus on a market (e.g., China venture), stage (e.g., Micro VC) or sector (e.g., Crypto). Honestly, you don’t even need to change the dimensions in the Tribe framework. I’ve adapted them here to just make a distinction between evaluating companies versus managers.

My mental model has three main dimensions (Manager, Strategy, and Model) and then three sub-dimensions (Model-Strategy Fit, Manager-Strategy Fit, and Manager-Model Fit). It is important to note that each LP will spike differently on these dimensions. Personally, I overweight Manager and Manager-Model Fit. This is not scientific but I would say that the majority of my evaluation is spent trying to understand the Manager (more on this in a later post). The radar chart below roughly represents how I might spike today. I’d also note that this has also changed over time for me and there may be times when I am searching for a specific strategy or model. It’s rare, but it happens.

The most important takeaway is:

The best managers I’ve ever seen have a compelling narrative that ties all of these elements together.

I hope to dive into each of these dimensions in subsequent posts. For now, here is a brief high-level breakdown of each dimension and how I think about it.

Manager

Manager is the most important piece of my evaluation. As most funds are typically a blind pool (i.e., I can’t identify the assets ahead of time) I am betting on an individual or team to allocate capital into the most compelling risk-adjusted opportunities. I’m trying to get to the ground truth about the person. After all, most funds and partnerships last longer than marriages in the U.S. Questions:

1. Is this individual or team highly ethical? Do they have a fiduciary mindset?

2. Is this individual an independent, curious, and differentiated thinker?

3. Does this individual have a brand that attracts talent and capital?

Model

Model covers aspects like portfolio construction, partnership structure (solo GP, equal partnership, CIO-type structure, etc.), value-add services, terms, etc. Jonathan Hsu, co-founder and General Partner at Tribe Capital, described it better than me. He said, “Product is the thing the customer is getting / hiring / buying from the company. The analogy for firms would be the way that the [manager] presents themselves to both companies (entrepreneurs) and capital (LPs).” Jonathan’s comments highlight something that is often overlooked by venture managers. There are two customers for VCs: limited partners and entrepreneurs. Both are important but what ultimately matters is the Model, or product, that you present to entrepreneurs as that will drive returns. Returns = an abundance of limited partners. Questions:

1. How are economics distributed across the Firm?

2. How are decisions made at the partnership level?

3. Where do you spend your management fees? Why?

Strategy

Strategy is the market of opportunities that the Manager is trying to address. Strategy covers everything from generalist vs. specialist, stage (Series A vs. Seed), geography (domestic vs. regional), market, and sourcing. Questions:

1. Do I believe this is a compelling part of the market?

2. Is there enough follow-on capital available in this region?

3. Why is now the right time for a sector-focused fund?

Manager-Model Fit

Manager-Model Fit covers a lot of different topics but the most critical is partnership dynamics. When I think of investments that haven’t worked it is often that there wasn’t Manager-Model Fit. This is a key component of any investment decision and why I tend to spike here in terms of weighting. Questions:

1. Is this individual well-suited to manage and develop the team?

2. Are they comfortable not being the sole-decision maker if they are operating as part of a team?

3. Are they likely to make it through generational transfer?

Manager-Strategy Fit

Manager-Strategy Fit assesses the extent to which the Manager fits with the overall strategy of the firm. Again, Jonathan nails the description of here as the “bounds of the asset subclass that is in their strike zone.” Questions:

1. Does the individual or team have experience investing in this stage?

2. Is the investor’s superpower relevant for the strategy?

3. Does the individual have to be in the region to be effective?

Model-Strategy Fit

Model-Strategy Fit assesses the extent to which the Model fits with the market of opportunities or Strategy. There is a famous quote attributed to Mike Maples at Floodgate that neatly sums up one piece of this dimension, “Your fund size is your strategy.”

This section covers plenty of other topics as well including:

1. Given the stage at which they are investing, do they have enough diversification in the portfolio?

2. Are the value-add services relevant to companies at this stage?

3. Is this the optimal fund structure for the strategy (i.e., private fund, hedge fund, holding company)?

4. Does this Model scale with this Strategy?

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From a manager’s perspective, this model and radar chart informs how LPs might think about their evaluation and corresponding diligence. For instance, if I were to spike on Strategy I would spend more time understanding the current market opportunity (e.g., Fintech, LatAm, or European Seed ecosystem). Not every LP will be deep in these sectors or regions so plan to address these points and emphasize why now.

My hope is to revisit most of these categories in greater detail in future posts so stay tuned. In the meantime, I would love any feedback as I continue to refine my own thinking.

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Thanks to Lindel Eakman at Foundry Group and Laura Roller at Cornerstone for reading early drafts and providing feedback on this post. Special thanks to Arjun Sethi and Jonathan Hsu at Tribe Captial for helping me refine this framework.

Disclaimer.