Venture Capitalists (VCs) aim to be both right and contrarian: the best way to maximize returns is by backing startups others overlook or undervalue.
Being Right
The VC model relies on the extreme success of a very few companies. VCs must identify businesses with the potential for outsized growth. This means discovering talented founding teams who are aiming to solve big problems in a way that will be defensible.
VCs typically invest out of 10-year funds. So timing your investments is important: companies need to benefit from a trend that will grow (and ultimately exit) during the 10 year life of the fund (note that one of our investment criteria is a large and growing TAM).
It’s been said that being early is often worse than being wrong. Think Friendster peaking 5 years before Facebook. Or the Apple Newton MessagePad launching in 1993, 14 years before the iPhone was launched.
If you invest too early, you don’t benefit from riding a trend during the life of a fund. Conversely, being late means you miss the incredible upside of getting in early before everyone else jumps on the bandwagon.
Being Contrarian
Being contrarian, or going against the consensus, is important due to the intense competition in popular investment areas. If everyone agrees that a company or sector is promising, you’ll have too many investors chasing too few companies, and valuations will be inflated, reducing potential returns.
If a VC can identify value where others see risk or uncertainty, they can invest at a lower valuation with the potential for much larger gains. The greatest opportunities often lie in areas where others are not yet looking or are underestimating.
Being contrarian recognizes that the most promising opportunities might initially sound crazy. But the most transformative ideas often sound crazy at first. Airbnb’s concept of strangers sleeping in other people’s homes seemed absurd until the company revolutionized travel. Rember that Uber initially focused on summoning black limousines in NYC and SFO.
By identifying areas where others aren't actively looking, and having an appetite for companies others don’t, you can create a unique advantage. You need to be open minded to picking up early signals (adjacent or niche markets, academic research, or underserved customer needs that point to broader future adoption).
Wrapping Up
VCs need to be both right and contrarian: this combination positions them to find undervalued opportunities that others miss, while still reaping the outsized rewards if the companies they back succeed.
Academic research shows that about 75% of venture-backed firms never return investors' capital (see next blog post on the Power Law). So, to reach outsized returns, it’s imperative that venture fund managers take calculated risk. In a world where everyone’s following playbooks, the real opportunities lie in writing new ones.
At Automotive Ventures, we’re underwriting 50x returns (see topic in future blog post). Following the herd just isn’t going to get us there.
Join us on the journey,
Steve Greenfield
