The Hubris of traditional Silicon Valley investors
The primary job of an investor is to find the best possible companies to invest in. Yet nearly all of them proudly ignore any company that hasn’t been referred by someone they know. You’ve heard it a million times:
“I get sooo many deals. I can only talk to the ones who are referred by someone I know.”
It’s completely illogical. It doesn’t follow that because you have one good source for companies that you wouldn’t want more good sources.
Their reply would be:
“I already have enough deals to look at.”
But do they have enough good deals to look at? If they’re ignoring a huge portion of potential deal flow how could they possibly?
The other common retort is:
“Anyone worth their salt will find a way to get a referral to me.”
Really? How would you know what you’re missing out on? Maybe they’ll just talk to more accessible people. Maybe they can’t find someone you know, but they can find someone another investor knows? Or maybe they’ll just get into Y Combinator and then you’ll pay a big premium to invest in them.
Y Combinator’s Secret Weapon
Y Combinator is by far the most successful and prominent investor in Silicon Valley now. Quite a few things make them different from traditional investors, but the one thing that makes them different from virtually every single investor, including many “accelerators”, is that they take applications for funding over the transom.
It’s not easy for them. They spend weeks and weeks sifting through thousands of applications to find the 5% that are worth talking to in person. Then they pay tens of thousands to fly those people out just to talk to them. They don’t really really care where they’re from, what schools they went to, or particularly: who they know.
Some of the very biggest YC successes have come in like this. Probably the majority of their best companies have. Even in cases where they had a referral it probably helped a lot to have a formalized application process. It forces companies to properly and fully pitch their idea.
Y Combinator’s formalized and meritocratic application process means the best companies rise to the top — not just the ones with the best referral, resume, or slickest elevator pitch.
Is it any wonder that Silicon Valley was so easily disrupted? A few good hackers took a close look at the problem and decided rightly to re-define it.
Opportunity for a new wave of Silicon Valley investors
Some smart VC is going to realize that one of the most important parts of YC is quite easily replicated and they’re going to make a killing doing it.
They’re going to put up a thorough application on the web like YC does, institute a rigorous process for evaluating them, and start treating that source of deals as their primary and best source of deal flow. They’ll start telling their referrals to “submit an application”.
And founders will hear about it. They’ll hear that there’s a VC who you can pitch without knowing his cousin’s friend who founded a company that failed 3 years ago. One who evaluates companies based on the fundamentals of the company and not whether other VCs are interested or not, or how slick you are.
It won’t be magic of course. The VC will still have to be smart enough to pick good companies and good at supporting them. They’ll have to offer competitive deal terms and have a great reputation.
Probably it will be some VC that’s new to the game. Someone with nothing to lose. Someone like what YC was like when they first started.
It’s the future
I think it’s inevitable that this will happen for all VCs. The world of handshakes and connections is great, but it creates an inefficient market. The ability to network and schmooze is not a requisite skill to building a great company. Certainly not in the early stages where it’s purely a game of finding product/market fit. Users don’t care who you know, where you went to school, or that you have Ron Conway on speed dial.
A lot of VCs are trying to use YC like a filter. The problem is that a lot of VCs are using YC as a filter. That means the top deals in every YC class are highly competitive. That’s why you’re hearing about inflated YC valuations.
There’s nothing inherently wrong with using YC like that, but if everyone is doing it you’re not going to have much of an advantage unless you’re offering overly-generous deal terms or one of a very few top firms.
Just like no technology company should outsource their technology no VC should be outsource their deal flow. Finding the best deals is the core of their entire business.
I predict that either all VCs will learn to accept and evaluate applications for funding over the transom or a select few will and they’ll outperform all but the very best schmooze-only VCs.
AngelList is already forcing their hand, and that levels the playing field even more for the best companies, but it’s more of a formalization of the “social proof”-based investing that VCs are currently relying on.
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