Investing based on domain knowledge and personal fit

The number of startup pitches that a venture capitalist receives is too high to understand the idea and team behind each startup in utmost detail. Since a venture capitalist has a fixed amount of time to allocate among potential investment opportunities, it’s necessary that we prioritize our time among startups. Although each investor will have a slightly different take on the attributes which they use to decide which startups are worth understanding in greater detail, there are two initial filters which most of us rely on. These are our domain knowledge and our personal fit with the startup team.

The first filter is designed to ensure that I only look at ideas in domains where I believe I have a strong edge in understanding the idea’s future potential. For example, I will be willing to go into a lot of depth to understand the idea behind a startup which uses positive and negative incentives to promote better human behaviors. As the result of my natural inclination and years of training, I tend to think in terms of the underlying motivating factors behind our actions, and how we can generate more of the desired actions by changing these factors. I’m therefore confident that, after having gone to great lengths to understand such a startup, my evaluation of its potential will be among the most accurate in the industry.

On the other hand, it’s very unlikely that I’ll spend a lot of time trying to understand a startup producing a novel medical device. I have no medical training and no exposure to such devices beyond what I’ve experienced as a hospital patient. Since I have no edge in evaluating the future impact of new medical devices, even if I spent many days researching a medical device startup my knowledge of its potential would be very limited compared to that of experienced practitioners. As a result, the investment decision that I make would be less informed and more prone to error.

So a startup needs to be playing in a domain where I have sufficient knowledge for it to attract my attention. Assuming that this is the case, the next filter I apply is that of personal fit with the team. Since a venture capitalist’s role is primarily one of providing support, not day-to-day execution, I need to fully trust each of the core team members’ ability and motivation to run the show. Passing this filter is more difficult than it sounds because it takes several interactions to build trust but only one to break it. After this trust has been established, some startups will ask for help on a weekly basis, while others will do so once a quarter. I don’t have a preference for either approach. This is because I’ve already made the investment decision knowing that the entrepreneurs are fully responsible for the business’ success or failure. Even if I were not there, I trust that the entrepreneurs will bring the best out of the startup.