Overlap 101: Silicon Valley vs Wall Street — How Venture Capital Differs from Traditional Investing

Welcome to our February newsletter, everyone! Things are really ramping up here at Overlap, and we’ve got some exciting updates to share with you shortly. You’ll also hear from other members of the team in subsequent editions as we build out our public presence and start bringing some of our key business activities to life.

Continuing on the educational theme of the past few monthly newsletters, this month’s post will attempt to give a high-level walkthrough of how the early-stage, Venture Capital investment industry differs from the world of "traditional," later-stage investing.

To keep the word count sub-astronomical, I've assumed the reader has a working knowledge of traditional investing (often referred to as "Wall Street" investing, given how much of the talent and infrastructure exists in Manhattan), and very little, if any, knowledge of Venture Capital (dubbed "Silicon Valley" investing, given how much of the talent and infrastructure exists in the Bay Area). Since I literally started my career at 60 Wall Street and have migrated to venture over time, it's a topic that I have an informed and differentiated perspective on. In many ways, this posts attempts to articulate my own intellectual journey, and help others follow in my footsteps.

While I've decided to focus on Venture at this point in my career, I don’t want to give anyone the impression that I feel either form of investing is “better” than the other. Both investment worlds are full of smart, hardworking people, seeking ways to generate value for their stakeholders. Fully functioning financing markets at all stages of a company's life cycle are an essential component of a robust economy. To be sure, there are also mean people, annoying people, and hypocritical people in both ecosystems. Neither coast has a monopoly on great ideas or virtue.

Wall Street and Silicon Valley each tend to act as their own echo chamber, in which different modes of behavior are valued and different activities are prioritized—leading to different efficiencies and pain points in both communities. If I can educate the reader on some of this nuance and help them understand the fundamental ways that venture differs from the traditional investing they're used to, then I’ve done my job.

With that in mind, let’s dig in.

Venture Capital: Riding the Risk

Venture Capital is a form of financing wherein investors provide "capital'' (ie, money in the form of equity or debt) to startup companies that are believed to have significant long-term growth potential. These investors are hoping that the growth of these companies will lead to an outsize return on their investment, commensurate with the outsize risk of investing in a small startup instead of an established business.

High risk is an ever-present, inherent feature of Venture Capital—it’s right there in the name. Per Merriam-Webster:

ven·ture (noun): an undertaking involving chance, risk, or danger.

Obviously, investors do what they can to minimize said risk (I’ll describe more below), but that risk is always there. Nobody is successful in every venture investment they make—even the best firms lose money on about half of their investments, and barely scrape by on another quarter of their deals.

With that level of failure assured, how does a venture investor make compelling investment returns? By (a) diversifying their investments across a number of these risky deals, and (b) making A LOT of money on the handful of deals that succeed. The disproportionate gain from a handful of investments out of a larger overall portfolio is referred to as the “Power Law distribution” of Venture investing, which is a fancy/extreme version of the old “80/20 rule.”

As a basic principle, in order to make a lot of money on an investment, it is best to (a) invest a relatively small amount of money up front, and (b) get a return (either through sale, dividend, IPO, or stock appreciation) of a lot more money than you invested. In Venture, in order for this to happen, the company you invest in needs to go from a tiny business with very little value (hence, your ability to invest a small amount up front) to a business that dominates, or creates, an industry or market channel, which will then be worth much more money than it was when you originally made your investment.

Given the competitive advantages that incumbent companies enjoy, the most common way for a small business to beat its established rivals is to develop/utilize a new technology that allows it to provide a good or service at a lower cost, or greater efficiency/benefit/ease, than said incumbents. This is why nearly all Venture Capital investments are into tech-oriented businesses, and why people typically think about the two concepts synonymously.

Compare all of this to traditional investing, wherein people invest in established companies with a base of customers and a product or service offering that is already accepted in the marketplace. Such companies aren’t likely to grow as fast as a tech startup, but they’re also unlikely to fail at anywhere close to the same rate. As a result, traditional investors often speak of the virtue of “hitting singles and doubles” and avoiding “striking out” (ie, losing money on a deal) at all costs, which leads to a portfolio of investments that can perform within a narrower band of success and failure than what venture investors experience.

Divergence

The amplified risk-return environment of Venture is the jumping-off point for a variety of differences between the Venture and Traditional investing environments.

FOMO (Fear of Missing Out)

Given the statistics, Venture investors are much more accustomed to investment failure than traditional investors. When it’s fully expected that half of your portfolio is going to be written off, it’s not as painful or reputation-damaging when an investment does. This approach is heresy to your typical Wall Street investor, who stays up at night sweating over troubled deals and doing everything they can to avoid any of their investments going to zero.

Conversely, Silicon Valley investors are constantly worried about NOT investing in the deal that hits it big. The drastic difference in outcomes between the "haves" (ie, making 30x+ your original investment) and the "have-nots" (ie, your investment going to zero) in Venture makes it all the more important to hit every home run possible. This FOMO-intense environment means that there's pressure for investors to pile into and “move fast” on deals that have created momentum in some way (a top-tier VC has invested in them; the company's charismatic CEO has struck a chord with media outlets; etc.), even at the expense of potentially questionable business fundamentals. This tendency will sometimes lead to anxious Venture investors ignoring red flags or skipping key diligence procedures, driven by the desire to catch what they perceive as a "hot" opportunity. It's this FOMO that has led to some of the most high-profile investment debacles in Venture, such as the implosions of FTX, Theranos, and most recently, this.

Which isn't to say that later-stage investors don't fall victim to fraud as well. It's just that, given the more defined diligence processes more consistently required in later-stage investing, the frauds have more skilled accountants. See: Enron, WorldCom, etc.

Safety in Numbers

Counterintuitively, another result of the high-risk nature of Venture is that investors don’t typically like to invest alone into a company. Nearly all Venture investment deals are done by syndicate, wherein one or two “lead” investors (typically established, “institutional” VCs who, through their lead positions, get an outsized voice in the company’s strategy, via board seats and otherwise) are joined by a host of smaller "non-leading" investors that subscribe for the remainder of a company's fundraise. Such an approach allows VCs to spread their capital over a larger amount of deals, thereby increasing the likelihood of backing the right breakout company. In addition, this approach allows a company and its lead investors to bring in a host of specialist, niche investors that bring different skills/attributes to the table, which can provide value-add to the company in the form of advice, guidance, connections, etc.

This, incidentally, is how Overlap fits into the landscape. We are typically a non-leading participant in venture investment rounds led by institutional VCs, wherein we are investing at the same time, at the same valuation, and the same (or very similar) terms as the lead VCs, but at a smaller check size. We then provide the companies we invest in with our knowledge/relationships/wisdom around capital structure, financial engineering, and corporate operations and governance, to the benefit of the company and its other investors. For this reason, we are able to position ourselves as "everybody's ally," since we are not competing with institutional VCs for lead roles, and we're not asking companies to make us their lead.

This syndicate approach contrasts with traditional private equity investing in the later stage, where returns exist in a narrower band and investors would rather have the benefits of concentrated ownership (control, larger board representation, etc.) than split the deal.

Furthermore, given that most later-stage companies are led by professional managers, not specialized technologists, it is somewhat easier for Wall Street investors to replace the C-Suite of a traditional company than for Venture Capital investors to do the same with leaders of a startup company. This is especially true at the early, product-building stages when senior leadership needs highly specialized technical knowledge. This means that later-stage investors typically have a larger control/say in the running of a company than in Venture investing, where investors are more beholden to the will of the founders and senior leaders.

As a result of all this, different investors in the VC community are collaborating on deals quite often, and find themselves on the proverbial “same side of the table” more often than in later-stage investing. This, in general, leads to more of a “sharing” atmosphere in Venture Capital, wherein competing funds find themselves as collaborators quite often, and therefore typically exchange knowledge and deal flow.

Timing is Everything

The desire for a Venture investor to improve their ability to spot great deals has led to a hyper-specialization of the sector, based not only on what industry a company is in (which is a common theme in traditional investing, too), but also where a company is in its life cycle.

The seemingly straightforward term "early stage" is actually a blanket term for several discrete "Series," as they're called in the Venture industry, which represent steps in a startup's funding journey as they grow from tiny to huge.

The breakdown of Venture investors by Series preference is a wonky topic, and one that the casual reader is fine to skip over. I'll try to keep the discussion as light as possible for these purposes, but have also included a link here for anyone that wants to dive into much more detail. To be honest, if you find yourself glazing over right now, just skip the next two paragraphs. You have my blessing ??.

The earliest Venture investment Series are for investors who focus on the transition from an innovative idea on paper to one that proves itself out in the real world and begins to establish its potential fit for a use case market. Investors in these rounds are called "Pre-Seed" and "Seed" investors, given they provide the companies with their initial "seed" money. Seed rounds are usually composed of Angel investors (wealthy individuals or seasoned executives who invest their own money according to their own whims) and/or specialized VCs who focus on this part of the life cycle.

The next few Series focus on a company's ability to generate and grow revenues at a pace commensurate with explosive growth. These next two rounds are called Series A and B, even though, given they come after Pre-Seed and Seed, they're actually the third and fourth round a company typically raises (yes, it's confusing. I TOLD you you could skip ahead, and now you're regretting not doing so ??). Series A & B rounds typically feature a larger proportion of established VC investors than angels as compared to the Seed stage, given that the sizes of the deals/checks are larger. Finally, there are the "growth investing" rounds (Series C and D), which take into account a company's continuing revenue growth and unit profitability metrics, as the company is now mature enough to demonstrate a relevant profit potential.

While this level of Series dissection may seem like overkill to those outside the industry, Series focus is an absolutely crucial element of a Venture investor's purview (the other one being which industries/technologies they cover). If you ask a VC to professionally self-identify, you'll almost always get an answer along the lines of, "I'm a [Series A], [Robotics] investor;" or, "I'm a [Life Sciences] investor focused on [Pre-Seed] and [Seed]." Bringing an investment opportunity to a tech VC, even a frontier tech VC, who focuses on a different Series stage or industry than that specific company, will almost always end with a polite "No thanks" (or, in many cases, a no-reply—the VC industry has a reputation for being notoriously passive-aggressive). In addition, each Series has its specific performance indicators that its investors are looking to see a company hit before writing a check for that stage. Woe be the startup that tries to raise its next round of capital if it hasn't met these metrics yet.

Assuming a startup performs very well, the size of the fundraise in each progressing Series will be successively larger than the one before it, as will the valuation at which new investors have to pay to buy their shares. In the best of scenarios, this keeps increasing until the company eventually "goes public" by offering its shares on a stock exchange through an IPO ("Initial Public Offering"). For many successful tech companies, this is the welcome party for its entrance into the world of later-stage, traditional investing—they have bridged the gap between Silicon Valley and Wall Street.

Traditional investing doesn't really have Series rounds the way that Venture does. Most of the time, in order for a company to be of interest to traditional investors, it must already generate (or prove its ability to generate) profit. Having said that, traditional investors do break themselves down into three overarching categories, based on the financial performance profile of the companies they invest in. There are still "Growth" investors in the later-stage world—they are looking for companies that still have strong top-line growth potential, albeit at a less dramatic pace than venture investments. Later-stage growth investors are typically the ones buying shares in a tech company's aforementioned IPO. On the other end of the spectrum are "Value" investors, who look to pick up investments in companies that have underperformed at a low price, with the hope/expectation that the business will improve, so they can reap a nice return as the equity value climbs back up. In between these two extremes are "Buy-and-Hold" investors, who believe the long-term fundamentals of a business will lead to slow and steady growth, and that they'll earn a modest return through a combination of solid performance and (potentially) dividend payments.

Of Valleys and Death

But what about the early-stage companies that don't continually experience rapid progress? Unfortunately, that's not often a happy story. Given the aforementioned risk associated with Venture investing, and the "Power Law" of returns we discussed earlier, startups that have sustained trouble with operating or financial performance are typically abandoned by investors and left for dead if they run out of financing. In some cases, if the company has developed some important level of traction, a combination of its existing investors will fill a short- or medium-term financing gap with either an "extension," "bridge," or "down" round, all of which are variations on the act of giving the company some small amount of funding at pricing/terms below what they'd otherwise receive if they were performing better. (Editor's Note: For an excellent, but also quite dry, primer on venture deal structuring, I would highly recommend the book Venture Deals, by Brad Feld and Jason Mendelsohn, which covers the topic extremely well without a lot of the high-handed puffery typically found in books by VCs.) Such funding gives companies enough runway to see if they're a great company facing temporary headwinds, or if there's a more fundamental issue that will prevent the exponential value creation that venture investors crave.

This is all fine and dandy when dealing with asset-light software companies that can dial their spending back relatively easily if they hit a rough patch. But what about frontier tech businesses that, despite performing well, have lumpy, real-world funding needs (capex, working capital, etc.) that aren't necessarily lined up well with whatever metrics they need to meet to attract the next Series of investors? Unfortunately, many of them go out of business if they don't find investors who have the right combination of foresight and specialization to fund them through these capital-intensive periods—the so-called Valley of Death. If that seems to you like a shame for the company, a travesty for society, and also an enormous economic opportunity to fill, then consider us in agreement! You now understand the driving motivation behind the formation of Overlap ??.

Three-Letter Acronyms (TLAs)

Like many other cloistered communities, VCs have a language of their own, the basic building block of which is the three-letter acronym (or "TLA" for short ??). The most important of these touch on the key attributes of the potential target companies that VCs examine when trying to determine whether or not to invest.

The most common acronym you're likely to hear from early-stage investors is the all-important "TAM", or "Total Addressable Market." TAM tries to figure out how big the ultimate buyer universe is for a company’s product or service. It helps investors understand if all the technical and commercial risk they're taking with a new investment is ultimately "worth it," or if the company will be working like crazy to create something that will never be big enough to merit the risks involved in getting there. Consider this: If someone pitched you on an incredibly promising hearing aid developed solely for use by elderly bungee jumpers, you'd probably be a pass…

Next up on the Venture acronym hit list is PMF, or "Product-Market Fit." This term asks whether the product or service the company offers is actually a good fit for its aforementioned market. Will customers really want what is being sold? Enough to abandon competitors? If so, at what price? These are the types of questions used to think through a company’s PMF, which are satisfied through dialogue with potential customers around the product and/or early evidence of strong order books, etc.

Connected on this same chain of thought is a startup’s GTM, or “Go To Market” strategy, which articulates how they plan to use their marketing/sales process and their PMF to capitalize on their TAM.

And, with that last sentence, I think I've proven my point about acronyms.

In addition to the investment-specific acronyms, venture has plenty of casual acronyms which investors use to communicate complex concepts, share eye rolls, etc. Just for fun, two common examples you might come across in casual discourse are:

• Tl;dr, which means “Too long; didn’t read,” and is industry shorthand for an incredibly concise executive summary of a piece of content.
• #HODL, which is used to convey an irrationally bullish view on an investment held by an unsophisticated investor (a term that was inadvertently created by an overly excited crypto bro on a chat board, and has since lived on in infamy).

Hoping that you all enjoyed this piece and came away with a better understanding of the differences in investing between early- and late-stage. Next month, we’ll set our sights on the concept of Brave Capital, which Overlap seeks to be a leading voice in pioneering.