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First Principle Thinking in the VC Space

Shi Mao from Conswall Capital Updated March 10, 2021

As the minimum unit of society, individuals often see their thoughts and behavior become the research topic of economists. If we generalize, the process of venture investment is actually an investor’s social science experiment in the real world. But what are the results? In this article, I use my experience at Conswall Capital to explore some valuable lessons on first principle thinking in the VC space.

The Power of Inertia: Some Old VC Habits Are Hard to Change

Isaac Newton defined inertia as an object that either remains at rest or continues to move at a constant velocity unless it is acted upon by an external force. This law of motion is also common in the venture investment space, occurring in both working styles and in cognitive function.


  • Working Style Inertia

With the inertia of working style, VC investors stick to diehard old habits when targeting potential ventures. This explains why entrepreneurs pitch their carefully prepared business plans to VC investors by all means possible but still go unanswered.

Usually, VC houses use the following 4 approaches to put a target in their crosshairs:

1. Transaction-driven

Financial advisors (FA) normally take the lead in this case. FAs are usually more diligent than VC investors and build trust with startup founders earlier. FAs are not held responsible for the investment performances, but an excellent FA should always be sensitive of the market and can immediately locate top-quality investable cases. After all, an FA does not represent a specific venture investor, but a group of them. To create a trading atmosphere and help project financing is their only purpose.

2. Event-driven

A sub-group of VC investors pile money at the door of industry shapers. These were Internet companies in the past a few years but semiconductor businesses or Chinese Academy of Sciences more recently. The sub-group then wait for a key person to spin off a new business so that they can seize the opportunity to cash in. Straight-A founders with repeated successes in trials of new projects are also sought after.

3. Network-driven

The entrepreneurs’ social connections act as their underwriters in this approach. Middle managers or executives in tycoon enterprises or founders of a VC-backed enterprise, with close friends or acquaintances who are investors of mainstream VC shops, are usually helpful underwriters in the founders’ network. In recent years, VC firms also recommend appealing projects to their peers, huddling together for benefits and the ability to spread the risks due to the great uncertainty of VC investment.

4. Research-driven

This approach is about making forward-looking industry analysis and prediction to determine the main racetrack and the runners with favorable odds. First, take a look at the trend of the United States, Europe and Japan (including population structure, per capita GDP, consumption habits, digital penetration rate, etc.). Then comes data capture from the three-party data provider or businesses’ disclosure (generally e-commerce platform sales, daily active user, App downloads and the growth) for analysis. Then, interviews are conducted with senior industry practitioners or independent advisors, and the racetrack takes its shape.

Normally, it’s not the racetracks but the runners that are elusive to bet on.

Some racetracks might be too underdeveloped to have promising runners. Even if the VC investor is bold enough to act as one runner by itself, it can suffer sudden infant death syndrome – which is not uncommon.

On other occasions, there are runners in a racetrack, but the winning runner shows no interest in financing. Internet traffic-oriented To Customer business or those in the semiconductor and pharmaceutical industry are capital-driven, but most of the rest are not. And the founders of some industries are even worried about VC investment.

There is also a more realistic situation. VC investors and promising runners in a certain racetrack just cannot connect with each other because China is too big, like a forest in darkness. Located in the 2nd or 3rd tier cities of China, some excellent projects develop in isolation. Consequently, A-share market listed companies without VC support are not uncommon.

All in all, the research-driven approach is the least practical. VC firms may do all the work but still find no suitable investment target. That’s why a series of funds may have a random volume of cases that belong to this category. But these cases are decisive in performance.


  • Cognitive Inertia

Besides working style, another aspect of VC inertia is cognitive.

AUM is the most persuasive index as to whether a VC firm is successful or not – DPI or IRR on the basis of a tiny AUM is just too accidental. That begs the question, though, why don’t giant VC houses completely monopolize the market? One answer is cognition inertia as it can restrain investors’ interest in novel things.

If we look at earlier dollar-denominated VC funds in Internet investment, the logical progression is to look at America, copy to China through a VIE structure to benefit from China’s demographic dividend, and then go public back in America. This is a typical kind of cognitive inertia, but such listed companies are now nowhere to be found.

By contrast, the success of the homegrown instant messaging software QQ has put its creator Tencent in an enviable position. Likewise, Kuaishou, Byte Dance and Pinduoduo are all local-born companies with no American precedents. Plenty of well-known VC shops once reached out to Kuaishou, but how many of them placed their bets? They failed to break through the constraint of cognition inertia.

I once spoke with my education-focused VC friend who recognized Haoweilai and Yuanfudao as promising companies but disapproved of my nomination of Offcn, a Chinaese vocational education and civil servant entrance examination training company whose market cap is now $31.3 billion and whose net profits for the year before last were $275.7 million. He said that vocational education has a low ceiling.

That might be a misunderstanding resulting from cognition inertia, or it’s me that knows nothing about VC investment in the education sector.

To be fair, this inertia can happen to us all. Recently, I visited some companies in the 2nd or 3rd tier cities of China to refresh my cognition. Some of the proven-overrated high-tech names are now overflowing from 1st tier cities to the 2nd or 3rd. There, tech giants are squandering millions of dollars to hire hundreds of doctors and thousands of salespersons to pursue an estimated value based on P/S ratio – not the exact product sales income.

By contrast, some grassroot companies who only hire dozens of research engineers are making visible profits in their verticals while providing surprisingly useful products. 

Without a protective barrier like other sectors have, the VC industry depends on people’s intellectual work and accumulated industry cognition. VC investors are different from doctors, lawyers or accountants. To bet on the best projects in the field, first and utmost you should fight against your own cognitive inertia. Embrace change and put aside inherent experience and narrow, logical thinking because investors are looking for the fastest-growing point in the industry.

A Magic Curve

微信图片_20210309111058.gif

With gravity as the only acting force, which is the fastest for a particle to reach the destination between two points?

Intuition might suggest the straight line. But it’s not.

In 1696, the Swiss mathematician John Bernoulli proved that there is only one fastest curve for the particle to follow between the two points, the cycloid.

I think that’s similar in the VC vertical: if a new racetrack can give us a great enterprise, it must be favored by the most important force – like gravity in the picture. This is known as “the overwhelming big trend.”

It is precisely because of the overwhelming big trend that the environment changes and new opportunities emerge. Otherwise, numerous smart people would have taken advantage of the chance in the past decade, and you would have been late. This explains why we have a saying in the VC Circle: invest in the new, not the old.

Find the right racetrack, and the entrepreneur is on board the cycloid. For instance, when online to offline (O2O) was popular, some startups eyed businesses such as door-to-door foot therapy, massage, car maintenance, house cleaning, and even pet bathing. But it’s door-to-door food delivery that won the game for its high frequency and strong demand among those in their 20s and 30s.

Let’s look at another example. When cloud computing became a hit in 2011 with Amazon Web Service, Chinese startups also took a huge interest in it, racking their brains for ways to cash in. Some started with consulting and training services; some acted as a business agent of foreign companies; and still some focused their attention on public cloud space, tapping the market value of e-commerce, digital games, SaaS and App developers. With loads of existing online users and exponential growth, this last pattern was the cycloid. It fueled the Chinese IaaS sector and catalyzed 2 public companies. Had the founders chosen a different path, they’d have lost out.

Investing in People

Riding the cycloid does not mean to follow the track all the way through – humans are unlike particles. They have thoughts, ideas and sentiments influenced by a complicated external environment. Alongside the hypothesis of the ‘rational person’, there is the discipline of Behavioral Finance, which acknowledges that individuals think differently. Consequently, different runners in the same racetrack follow different trajectories, and startups are differentiated hence. This echoes another saying in the VC circle: investment is all about investing in people.

In regard to entrepreneurship, individual differences mainly fall into the following two categories:

Ÿ   Macro level: big picture thinking

Ÿ   Micro level: executive capacity

Big picture thinkers are never satisfied with small success nor care about shortcuts. Shortcuts, like the straight red line, sometimes mean losing the game in the final. And executive capacity is equally important as big picture thinking. Many people can bring up or understand a good idea, but few materialize it – that is where executive capacity comes in. We VC investors usually infer this capacity from a business plan’s final part – financing purpose.

Executive capacity means quick practice and reiteration rather than endless preparing.

An example of this is the iPhone. Ever since the iPod’s launch, Steve Jobs had always wanted both music listening and email function incorporated into iPhones. But due to limitations from chips and bandwidth, such inserted functions were bound to work slowly on iPhones.

Steve Jobs just wouldn’t let it go, though. Engineers had to overwork 80 hours a week, explain technical difficulties to executives, and keep all this secret to themselves.

Andy Grignon, then chief engineer of iPhone wireless software development, said the first-generation iPhone was not ready for a press conference. It could get disconnected from the network or powered off for no reason.

But Steve Jobs pressed forward nonetheless. Engineers had to write code to make signal bars always full, suggested that he follow a certain order in presenting functions, and prepared enough backup iPhones for unexpected situations to guarantee a good press conference.

Had the iPhone team never iterated its product generation by generation, but waited for everything to be ready to launch the perfect product, competitors might have beaten them to the punch.

Learning from History

Reviewing the successful startups that Conswall has invested in, we found that they have several features in common. They find the correct niche market, continue to march in small steps and upgrade the products repeatedly to make them more competitive and closer to perfect. When startups in the same vertical all develop mature products, this is the beginning of the final struggle. I compare this to mountain climbing – whether you started from the south or the north foothill, all paths intersect with each other one step away from the mountain top at the final point. After that, the winner will be the winner and the loser will be the loser.

To conclude, VC investors need to avoid negative influence of working style and cognitive inertia, bet on the right racetrack and choose the runner with big picture thinking as well as high executive capacity. That - betting on the winner - is the first principle thinking in the VC space.

 


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CHINA-BASED
GLOBAL PLATFORM
FOR GPs & LPs
FOF WEEKLY Account terms of service
1. Members registered in this website must abide by the provisions on the administration of Internet electronic announcement service, and shall not publish information such as defamation of others, invasion of others' privacy, infringement of others' intellectual property rights, spread of viruses, political speech, commercial information, etc.
2, in all the articles published in the site, the site has the final right to edit, and reserve the right to print or publish to a third party, if your information is not complete, we will have the right to use your work published in the site without any notice.
3. During the registration process, you will choose the registration name and password. The choice of registration name shall comply with laws, regulations and social ethics. You must keep your password confidential and you will be responsible for all activities that take place under your registered name and password.
Already have an account? Sign in!
E-mail adress

First Principle Thinking in the VC Space

Shi Mao from Conswall Capital Updated March 10, 2021

As the minimum unit of society, individuals often see their thoughts and behavior become the research topic of economists. If we generalize, the process of venture investment is actually an investor’s social science experiment in the real world. But what are the results? In this article, I use my experience at Conswall Capital to explore some valuable lessons on first principle thinking in the VC space.

The Power of Inertia: Some Old VC Habits Are Hard to Change

Isaac Newton defined inertia as an object that either remains at rest or continues to move at a constant velocity unless it is acted upon by an external force. This law of motion is also common in the venture investment space, occurring in both working styles and in cognitive function.


  • Working Style Inertia

With the inertia of working style, VC investors stick to diehard old habits when targeting potential ventures. This explains why entrepreneurs pitch their carefully prepared business plans to VC investors by all means possible but still go unanswered.

Usually, VC houses use the following 4 approaches to put a target in their crosshairs:

1. Transaction-driven

Financial advisors (FA) normally take the lead in this case. FAs are usually more diligent than VC investors and build trust with startup founders earlier. FAs are not held responsible for the investment performances, but an excellent FA should always be sensitive of the market and can immediately locate top-quality investable cases. After all, an FA does not represent a specific venture investor, but a group of them. To create a trading atmosphere and help project financing is their only purpose.

2. Event-driven

A sub-group of VC investors pile money at the door of industry shapers. These were Internet companies in the past a few years but semiconductor businesses or Chinese Academy of Sciences more recently. The sub-group then wait for a key person to spin off a new business so that they can seize the opportunity to cash in. Straight-A founders with repeated successes in trials of new projects are also sought after.

3. Network-driven

The entrepreneurs’ social connections act as their underwriters in this approach. Middle managers or executives in tycoon enterprises or founders of a VC-backed enterprise, with close friends or acquaintances who are investors of mainstream VC shops, are usually helpful underwriters in the founders’ network. In recent years, VC firms also recommend appealing projects to their peers, huddling together for benefits and the ability to spread the risks due to the great uncertainty of VC investment.

4. Research-driven

This approach is about making forward-looking industry analysis and prediction to determine the main racetrack and the runners with favorable odds. First, take a look at the trend of the United States, Europe and Japan (including population structure, per capita GDP, consumption habits, digital penetration rate, etc.). Then comes data capture from the three-party data provider or businesses’ disclosure (generally e-commerce platform sales, daily active user, App downloads and the growth) for analysis. Then, interviews are conducted with senior industry practitioners or independent advisors, and the racetrack takes its shape.

Normally, it’s not the racetracks but the runners that are elusive to bet on.

Some racetracks might be too underdeveloped to have promising runners. Even if the VC investor is bold enough to act as one runner by itself, it can suffer sudden infant death syndrome – which is not uncommon.

On other occasions, there are runners in a racetrack, but the winning runner shows no interest in financing. Internet traffic-oriented To Customer business or those in the semiconductor and pharmaceutical industry are capital-driven, but most of the rest are not. And the founders of some industries are even worried about VC investment.

There is also a more realistic situation. VC investors and promising runners in a certain racetrack just cannot connect with each other because China is too big, like a forest in darkness. Located in the 2nd or 3rd tier cities of China, some excellent projects develop in isolation. Consequently, A-share market listed companies without VC support are not uncommon.

All in all, the research-driven approach is the least practical. VC firms may do all the work but still find no suitable investment target. That’s why a series of funds may have a random volume of cases that belong to this category. But these cases are decisive in performance.


  • Cognitive Inertia

Besides working style, another aspect of VC inertia is cognitive.

AUM is the most persuasive index as to whether a VC firm is successful or not – DPI or IRR on the basis of a tiny AUM is just too accidental. That begs the question, though, why don’t giant VC houses completely monopolize the market? One answer is cognition inertia as it can restrain investors’ interest in novel things.

If we look at earlier dollar-denominated VC funds in Internet investment, the logical progression is to look at America, copy to China through a VIE structure to benefit from China’s demographic dividend, and then go public back in America. This is a typical kind of cognitive inertia, but such listed companies are now nowhere to be found.

By contrast, the success of the homegrown instant messaging software QQ has put its creator Tencent in an enviable position. Likewise, Kuaishou, Byte Dance and Pinduoduo are all local-born companies with no American precedents. Plenty of well-known VC shops once reached out to Kuaishou, but how many of them placed their bets? They failed to break through the constraint of cognition inertia.

I once spoke with my education-focused VC friend who recognized Haoweilai and Yuanfudao as promising companies but disapproved of my nomination of Offcn, a Chinaese vocational education and civil servant entrance examination training company whose market cap is now $31.3 billion and whose net profits for the year before last were $275.7 million. He said that vocational education has a low ceiling.

That might be a misunderstanding resulting from cognition inertia, or it’s me that knows nothing about VC investment in the education sector.

To be fair, this inertia can happen to us all. Recently, I visited some companies in the 2nd or 3rd tier cities of China to refresh my cognition. Some of the proven-overrated high-tech names are now overflowing from 1st tier cities to the 2nd or 3rd. There, tech giants are squandering millions of dollars to hire hundreds of doctors and thousands of salespersons to pursue an estimated value based on P/S ratio – not the exact product sales income.

By contrast, some grassroot companies who only hire dozens of research engineers are making visible profits in their verticals while providing surprisingly useful products. 

Without a protective barrier like other sectors have, the VC industry depends on people’s intellectual work and accumulated industry cognition. VC investors are different from doctors, lawyers or accountants. To bet on the best projects in the field, first and utmost you should fight against your own cognitive inertia. Embrace change and put aside inherent experience and narrow, logical thinking because investors are looking for the fastest-growing point in the industry.

A Magic Curve

微信图片_20210309111058.gif

With gravity as the only acting force, which is the fastest for a particle to reach the destination between two points?

Intuition might suggest the straight line. But it’s not.

In 1696, the Swiss mathematician John Bernoulli proved that there is only one fastest curve for the particle to follow between the two points, the cycloid.

I think that’s similar in the VC vertical: if a new racetrack can give us a great enterprise, it must be favored by the most important force – like gravity in the picture. This is known as “the overwhelming big trend.”

It is precisely because of the overwhelming big trend that the environment changes and new opportunities emerge. Otherwise, numerous smart people would have taken advantage of the chance in the past decade, and you would have been late. This explains why we have a saying in the VC Circle: invest in the new, not the old.

Find the right racetrack, and the entrepreneur is on board the cycloid. For instance, when online to offline (O2O) was popular, some startups eyed businesses such as door-to-door foot therapy, massage, car maintenance, house cleaning, and even pet bathing. But it’s door-to-door food delivery that won the game for its high frequency and strong demand among those in their 20s and 30s.

Let’s look at another example. When cloud computing became a hit in 2011 with Amazon Web Service, Chinese startups also took a huge interest in it, racking their brains for ways to cash in. Some started with consulting and training services; some acted as a business agent of foreign companies; and still some focused their attention on public cloud space, tapping the market value of e-commerce, digital games, SaaS and App developers. With loads of existing online users and exponential growth, this last pattern was the cycloid. It fueled the Chinese IaaS sector and catalyzed 2 public companies. Had the founders chosen a different path, they’d have lost out.

Investing in People

Riding the cycloid does not mean to follow the track all the way through – humans are unlike particles. They have thoughts, ideas and sentiments influenced by a complicated external environment. Alongside the hypothesis of the ‘rational person’, there is the discipline of Behavioral Finance, which acknowledges that individuals think differently. Consequently, different runners in the same racetrack follow different trajectories, and startups are differentiated hence. This echoes another saying in the VC circle: investment is all about investing in people.

In regard to entrepreneurship, individual differences mainly fall into the following two categories:

Ÿ   Macro level: big picture thinking

Ÿ   Micro level: executive capacity

Big picture thinkers are never satisfied with small success nor care about shortcuts. Shortcuts, like the straight red line, sometimes mean losing the game in the final. And executive capacity is equally important as big picture thinking. Many people can bring up or understand a good idea, but few materialize it – that is where executive capacity comes in. We VC investors usually infer this capacity from a business plan’s final part – financing purpose.

Executive capacity means quick practice and reiteration rather than endless preparing.

An example of this is the iPhone. Ever since the iPod’s launch, Steve Jobs had always wanted both music listening and email function incorporated into iPhones. But due to limitations from chips and bandwidth, such inserted functions were bound to work slowly on iPhones.

Steve Jobs just wouldn’t let it go, though. Engineers had to overwork 80 hours a week, explain technical difficulties to executives, and keep all this secret to themselves.

Andy Grignon, then chief engineer of iPhone wireless software development, said the first-generation iPhone was not ready for a press conference. It could get disconnected from the network or powered off for no reason.

But Steve Jobs pressed forward nonetheless. Engineers had to write code to make signal bars always full, suggested that he follow a certain order in presenting functions, and prepared enough backup iPhones for unexpected situations to guarantee a good press conference.

Had the iPhone team never iterated its product generation by generation, but waited for everything to be ready to launch the perfect product, competitors might have beaten them to the punch.

Learning from History

Reviewing the successful startups that Conswall has invested in, we found that they have several features in common. They find the correct niche market, continue to march in small steps and upgrade the products repeatedly to make them more competitive and closer to perfect. When startups in the same vertical all develop mature products, this is the beginning of the final struggle. I compare this to mountain climbing – whether you started from the south or the north foothill, all paths intersect with each other one step away from the mountain top at the final point. After that, the winner will be the winner and the loser will be the loser.

To conclude, VC investors need to avoid negative influence of working style and cognitive inertia, bet on the right racetrack and choose the runner with big picture thinking as well as high executive capacity. That - betting on the winner - is the first principle thinking in the VC space.