What we do
Early stage investing (pre-seed, seed, and Series A) is wildly inefficient. About 98% of investment is made by non-professional investors (friends, family, and angels) – quite the ad hoc and sporadic affair. This inefficient system is rigged to reward the dedicated and expert pro investors while leaving the non-pros out in the cold, blind to the potential opportunities and returns.
At Diffuse, we want to fix this. We believe more smart investment yields more successful entrepreneurs, which leads to more innovation and societal growth. But we have to start with the dollar bills. Diffuse deconstructs venture capital and then diffuses the work to a global network of experts to scalably and intelligently deploy capital into early stage startups.
That’s a lot to unpack. Let’s start with…
The trouble with Micro VCs
Most early stage professional investors are venture capital funds (“micro VCs”) with $50 MM or less in assets under management (“AUM”). Normally, 1-2 General Partners (“GPs”) raise money from their Limited Partners (“LPs”) and the GPs have full discretion over the fund’s investments. These GPs are usually either former entrepreneurs or good at raising money (i.e., former investment bankers).
I’m Kenny, and I know a thing or two about micro VCs because…I am one. I co-founded a fund with some experience operating in a startup and raising money, but none in venture investing. To paraphrase my Ma, when I point a finger, it’s with three pointing back at me.
Reinventing the Wheel
All early pro investors need to do three tasks: find investment opportunities, underwrite them, and raise money. (I’m ignoring fund operations because it doesn’t add value.) Each of these three things requires specific skills…and I’ll describe them glibly. Finding investment opportunities means going around and having your butt kissed. Underwriting means digging into data and spreadsheets. Raising money means kissing other people’s butts.
The odds that one person can do all three of these well are…low…yet micro VCs with 1-2 GPs try to do it all. Why? Well, GPs are building their track record to raise later, larger funds. But that requires unique brands, approaches, and capital sources. So, they reinvent the wheel.
They travel a lot to meet entrepreneurs even though that’s wildly inefficient and a terrible return on their time (ignoring future funds). They choose which investments to make using their own underwriting approach that largely consists of gut feel and heuristics. They raise money from the folks that already trust them (unless they’re really lucky).
I know because this is exactly what I did.
If the goal is to maximize returns for your investors, then this approach strikes me as kind of…dumb. It also doesn’t scale well because…
If you’re good, you stop doing it.
Let’s assume you’re one of the GPs that crushes it. Your first fund had $10 MM AUM, the second $20 MM, and the third $100 MM.
Now…you’re no longer an early stage investor.
You simply cannot, and should not, write a $200k check anymore. It’s a poor use of your time and doesn’t move the needle for your fund’s return. The only way to justify doing so is for the pro rata rights so you can cut bigger checks in later rounds. That’s not early stage investing. That’s mid-stage investing, where a tactic happens to be buying a seat at the table with small initial checks.
Your deals come from different sources (there is a lot less finding a diamond in the rough no one has heard of), your underwriting is based on actual financials not the back of an envelope, and you’re raising money from institutions not individuals. It’s a different business.
The Agency Problem
Not only are you now in a different business, but you also have different incentives.
VCs get paid with two different types of fees.
Management fees are normally charged as a percentage of assets under management (AUM). This is to cover employee overhead and the industry standard is about 2% per year carried interest (“carry”). You can think of as a profit sharing. Normally, it’s set at 20% which means, if your investors make a profit of $100, the VC keeps $20 of it.
In an ideal world, the LPs would want the GPs to only be paid with carry and no management fee, so everyone’s interests are aligned. The key word is “ideal.”
When two people are running a $10 MM fund, the management fee isn’t going to make anyone rich and they care deeply about the investor’s returns because that’s their track record. When two people are running a $100 MM fund, they’re each probably pulling down over $1 MM in income per year. The carry can be huge, but they’re going to get rich either way. Their real incentive is to not suck so they can raise another fund.
They call this the agency problem and it’s a rampant issue in every corner of financial services (and beyond).
The Walled Garden
VC is not rocket science. VCs try really hard to make it seem like it is.
I truly don’t understand why VC has such mystique. When we spun up WLV, I didn’t realize I wasn’t supposed to be able to. It wasn’t until business school that I saw first hand the fascination my fellow classmates had for the space. It’s one of the most popular tracks for new MBAs across the globe and there are a lot of sharp elbows vying for every entry-level position. Part of me thinks we have a culture of rooting for the underdog so venture gets a halo effect from the entrepreneurs they work with.
A much more cynical part of me thinks that by the time you figure out how things work under the hood…you’re in the walled garden…and it’s pretty damn comfortable. You can press the advantage of your network and create some serious wealth for yourself. Why upset the applecart?
What does this mean for an Investor?
There are really two types of early stage investors: pro and non-pro.
Good news! Capital allocation inefficiencies are great for shrewd investors! All you have to do is spend all of your time learning about startups, networking with founders, and gaining deep domain expertise and you’ve got a pretty good shot at above average returns.
That sure is a lot of work though.
A non-pro Investor is anyone who doesn’t invest in early stage ventures full time. Think high net worth individuals with jobs and a family. This is the vast majority of Investors since it’s rather rare to find someone with the inclination and financial security to handle the poor micro VC economics for the first few years to build a track record.
Non-pros want to access early stage investment opportunities…but they don’t have the time or expertise to do it themselves. Their options are limited. They can invest in micro VC funds…but we just discussed the issues therein. They can also use one of the investing platforms which aggregate a number of opportunities, but that still requires they have the ability to separate the wheat from the chaff.
If only there was another way.
As already stated, Diffuse is a way to intelligently and scalably deploy capital into early stage startups. That ideal is the north star by which we navigate. Our Ecosystem is made up of expert Lead Investors who source and diligence deals and then secure co-investment allocations for Diffuse. Hence, intelligent. Our Syndicators then reach out to select investors who can then invest alongside the Lead. We free the expert investors from having to raise money from individual investors (a terrible use of their time). Hence, scalable. As an added bonus we do so in such a way that everyone cares first and foremost about helping the company they’re investing in.
So how does it work?
Everyone in the Diffuse ecosystem works for carry. We all only make money if the company succeeds and the investor profits. We don’t charge individual investors management fees and profit on the size of our capital pool.
Deconstructing Venture Capital
In a previous episode of this manifesto (scroll up a bit), I talked about how all micro VCs have to excel at the same tasks. We use carry to incent experts to do each task. Rather than sourcing deals by traveling to conferences and creating our own network of Entrepreneurs, we give carry to Originators who already have strong networks (why reinvent the wheel?). Rather than becoming an expert in all things startup, we recruit Lead Investors who earn carry for performing the diligence, writing the first check, and giving Diffuse an allocation (which in turn gives them investment leverage). Rather than raising capital ourselves, our Syndicators earn carry for any part of the allocation they place.
How does this solve the problems?
Recall micro VCs tend to try and reinvent the wheel and do all the tasks with their small team. Now they can specialize in the part of early investing they’re best at. If it’s sourcing deals, Diffuse gives them expert Leads to make the investment. If it’s underwriting a deal, we give them leverage. If it’s raising capital, we can give them high potential fully vetted deals. Heck…they can even change which role they fill on a deal-by-deal basis.
If you want to invest in early stage startups without dedicating your life to it, we’re your way in. Our diligence standards are incredibly high and we only accept the most promising opportunities into the Ecosystem. As always, only invest what you can stand to lose, since early stage venture is crazy risky, but you can rest assured you’re investing on the back of an institutional-grade process.
Yes, we still charge you carry. But there is no management fee, which means everyone involved only makes money if you do.
The Big Why
Early stage startup investing today is a pretty terrible experience for all involved. Not least of which is the Entrepreneur, who has to spend an obscene amount of time navigating the previously mentioned ad hoc and sporadic investing landscape…when they should really be building an earth-shattering enterprise.
We want to free capital to flow to the best Entrepreneurs so they are empowered to drive innovation and improve the world we all live in.
Learn more about how to invest, syndicate, and raise with us.
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