The secret ‘law’ every successful LP understands


Selection Choice

By Jason Portnoy, Subtraction Capital

A significant event happened in early 2013: a new venture capital fund was born. This may not sound so significant to you, but it was significant to me and my partners at Subtraction Capital. We wanted to return to the origins of venture capital, a boutique tradecraft where successful entrepreneurs used their new-found wealth and experience to help launch the next generation of entrepreneurs.

We selected an irreverent name that spoke directly to founders, CEOs and executives of startups and who already know or have quickly realized that if they don’t aggressively work to shield themselves and their companies from distractions, their companies won’t survive.

We believed that helping teams identify and subtract distractions was an important way that we could leverage our operating experience to help our portfolio companies. We put 20 percent of our personal capital into our first fund, closed it fairly quickly and then got to work.

Fast forward almost three years and our model is clearly working. We have a thriving portfolio and we’ve had a chance to work with and learn from some amazing teams. But something else has happened during that time that I find interesting. We are now higher on the list of calls that entrepreneurs make when they start raising their seed or Series A rounds.

In a discussion about this a year ago, Paul Willard, my co-founding partner, commented that we were seeing “proverse selection.” It’s a term he used extensively in his years as an aerodynamicist at Boeing.  In that context, the term refers to an aerodynamic effect that creates desirable “proverse yaw” rolling motion in an aircraft design as opposed to an undesirable “adverse yaw” rolling motion.

In the context of our venture capital work, we started to see that a powerful “law” was at play. This law appeared to be a six-step cycle that can be understood as follows:

  1. When we started, Subtraction Capital had no brand equity. Our past experience at companies like PayPal, NextCard, Palantir Technologies, Coupons.com and Atlassian gave us powerful networks, but we still did not have a brand that was associated with venture capital investing. As a result, we started by investing opportunistically in companies that were introduced to us through our then-existing networks or which we came across at conferences and then chased down on AngelList.
  2. We worked closely with those companies to help them as much as we could. This typically involved applying our operational experience to help them solve problems, or avoid certain common problems altogether, and providing introductions to individuals in our networks that could help them scale their businesses.
  3. As several of the Fund 1 portfolio companies have grown and scaled into more successful enterprises, their rising brand equity is inuring to the benefit of our brand.
  4. Because our firm is associated with more successful companies, teams are now approaching us earlier in their fundraising processes. They want our positive brand attributes to also benefit their company and brand. The logic here, which I think is mostly accurate, is that having high-quality investors helps you recruit better employees and raise money from other high-quality investors.
  5. Now that we see companies earlier in their fundraising processes, and see more of them in general, we have greater choice in our investment selection process.
  6. If we do a good job of identifying the best companies to invest in, and are able to help them, these investments will lead to quality outcomes with incremental brand equity for the company and our firm, and the cycle begins to reinforce itself.

To summarize, Higher quality outcomes leads to a larger pool of high-quality investment alternatives, which in turn lead to higher quality outcomes. We call this the “Law of the Proverse Selection Cycle,” as illustrated in the accompanying image.

Selection Choice Subtraction Capital

Benefits of the Proverse Selection Cycle

We realize that building an enduring venture capital brand is a multi-decade endeavor, and that we are just getting started. The Proverse Selection Cycle will have benefits that we only realize and appreciate many years from now. However, there is one benefit that we can already see, and which we are thoughtfully taking advantage of: time allocation.

Because of the quality of the teams and companies we get introduced to, we spend very little time sourcing deals. As a result, we have a lot of time which we can spend with our portfolio companies. This, hopefully, not only helps them be more successful, but allows us to build meaningful working relationships and also to learn from them. In addition, because we spend so much time with the companies, we get to know multiple layers and functional teams inside their companies, not just the CEOs. This operating exposure keeps our skill sets current and these new relationships expand our network, both of which will help all of our other portfolio companies, further reinforcing the cycle.

Why this ‘law’ matters to LPs

The Proverse Selection Cycle is powerful, and we believe it is a major reason that the best venture firms stay on top of the charts, and why their returns are so much better than their peers. If a VC firm honors the law, they become a magnet for the best teams and companies, which gives them such a large advantage that their competitors are constantly trying to play catch-up.

We are only just beginning to understand all of the ways that we ourselves need to cultivate the cycle. One hypothesis I have is that maintaining a disciplined fund size is one of the most important ways to maintain it. If a firm wants to raise a significantly larger fund yet still invest at a similar stage to where they were investing previously, I think this puts them in a dangerous position. Sitting on a large pile of capital that they have to deploy creates pressure to invest, even for the most mindful investor.

If a fund is too large, there may be a tendency to gradually invest in companies just for the sake of deploying capital, not because they are the best investments. If this happens and the quality of the investments degrades, the cycle will start to break. LPs should be sensitive to signals where firms are raising significantly larger pools of capital with the intention of deploying it in the same stages where they were investing previously.

I also believe that the power behind the Law of the Proverse Selection Cycle may be most exaggerated in venture capital. For example, I don’t believe you would experience this same cycle as the manager of a mutual fund. In that case, creating a brand for your firm would almost certainly translate to more asset gathering ability, but it would not necessarily translate to getting access to better investment opportunities for your fund. That investment class doesn’t appear to have a similar cycle dynamic where a better brand actually leads to better investment performance.

Institutional LPs already think about venture capital differently from other asset classes that they allocate capital to, but I want to emphasize how important this brand consideration should be in their venture capital allocation selection process.

Honoring the cycle

The Proverse Selection Cycle exists in venture capital, whereby the success of a venture capital firm’s portfolio companies leads to higher quality investment opportunities for the firm, which then leads to better portfolio company outcomes and a positive, self-reinforcing cycle. This cycle does not build momentum overnight, but if it is understood, honored and cultivated, it can be a valuable tool for a venture capital firm, creating powerful brand dynamics and value over the long term.

You might have noticed that I have not mentioned anything about investment returns. Our philosophy at Subtraction Capital is that if you understand and respect the underlying dynamics at play in a financial ecosystem and get them right, the returns will follow naturally.

The top venture firms have had the Law of the Proverse Selection Cycle working in their favor for many years, some of them for decades. I believe their dominant positions and stellar returns support our reasoning. If they continue to honor the cycle, they will consistently deliver results that far exceed the average return for the asset class.

Jason Portnoy is founding partner at Subtraction Capital. He can be reached at [email protected].

Photo illustration from Shutterstock.

Photo illustration of the “Law of the Proverse Selection Cycle” from Subtraction Capital.

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