PS#002: 6-Step Guide to Building an Investment Thesis
Today, I'm going to teach you how to build an investment thesis, step by step.
This is the main job of being a venture capitalist.
We use our theses to try and predict some portion of the future. An investor's thesis on a company, a space, an industry, etc. will drive their strategy, decisions, and allocation of capital.
By building your own thesis, you're showing that you can do the job.
Unfortunately, most people keep their thesis too high-level. They don't get into the details. They are too afraid of being wrong. Well, I’ve got a secret for you…
Most venture capitalists are wrong most of the time.
You don’t need to worry about being wrong.
You need to worry about showing the right process.
It’s all about the process.
We’re going to walk through this process in detail, but before we do, I want to highlight something.
When I say this is the job, I mean it. You’ll do this over and over again in your career, especially early on. It will be a significant portion of your day-to-day work.
If you hate this process or decide it’s just not something you’d like to do every day, you don’t really want to be a venture capitalist.
And, that’s OK.
Better to figure this out before you waste all this time pursuing a job in venture capital.
Plus, there’s good news!
This exercise will still be very useful as you pursue other career paths.
By the end of this process, you’ll have…
Learned a ton about a space of interest to you
Created a list of mature companies & startups in the space
Built connections & relationships with people working in this space
As you can see, it’s a worthwhile exercise for anyone looking to switch careers.
Alright, without further ado, let's get started...
Step 1: Pick a problem.
Choose a space that is interesting to you.
I recommend building on a niche interest. Why? A few reasons...
It will be much more fun
You will be more willing to dive into the details
You'll have more genuine and authentic discussions with others
It will lead to a unique domain expertise for you, providing a competitive advantage
Here are some examples on how you can try to identify a problem...
Personal experience
Observing & researching an industry
Speaking with customers in a specific space
Reviewing legacy or older companies/technology
Here's an example of this in action...
I used a combination of the first and fourth bullet to build a thesis on the advancement of legal technology. In my previous work, I couldn't believe how manual and time-consuming most legal work still was, despite the advances in AI and other technology. It often slowed down deals, driving me and my team nuts. When I researched the legacy providers in the space, I saw that the software hadn't been updated in decades.
From the outside, this looked like an opportunity, but I needed to do the work.
Step 2: Why is this a BIG problem?
A lot of aspiring investors will stop with the first step.
They don't get into the details to prove (or disprove) that the problem identified is actually worthy of venture investment.
To do this, we'll attempt to better understand the dynamics of the market, including its size and competitive landscape. This is an important part of the thesis building process because it gives us insights into the following...
Level of risk
Revenue potential
Competitive dynamics
Potential return on investment
I'll give you a step-by-step process for estimating a market's size and identifying its competitive landscape.
We’ll start with market sizing. Market sizing follows 4 steps...
Define the customer
Take a 30,000-foot view
Build a bottom's up analysis
Review potential growth opportunities
Let's dive into each of these...
Define the customer: Break down the different customer profiles that deal with this problem. Segment them by their different characteristics, such as demographic, size, business vs. individual, behavior, use case, geography, etc. Ultimately, align groups that will follow a similar buying process or use case. I highly recommend doing calls with different customers in each segment to get a deeper understanding.
30,000-foot view (top's down analysis): Take a 30,000-foot view of the market – size, trends, players, etc. – to get a better understanding of how it’s evolving. This will often require a critical review of available research on a market. Everyone is trying to sell their perspective, so you don’t want to fully depend on this type of analysis. It’s simply directional. Analyze the underlying assumptions and see if you agree or disagree.
Build a bottom's up analysis: Construct the addressable markets for each customer profile by identifying the number of customers in each segment and multiplying it by the likely pricing. Review these segments and decide how much of the addressable market will be available to the company at each stage of its growth. You'll use this to see if there is a reasonable path from the current traction to $50M+ in revenue.
Review potential growth opportunities: Build a perspective on how this market will grow/change overtime – new problems, customer segments, products, use cases, trends, behaviors, etc. Remember, markets are not stagnant, they change over time.
Finally, a few “rules of thumb”...
Vertical markets – it tends to be easier to capture more of the value chain, so investors look for markets with $500M+ revenue potential
Horizontal markets – with a more complicated go-to-market process across many industries, investors are looking for $1B+ revenue potential
Step 3: What are the current & future solutions?
To answer these questions, we need to identify the competitive landscape.
The goal of the competitive landscape is to help an investor understand who/what will be competing for the market opportunity (i.e., revenue) that we sized in the previous step.
A typical competitive landscape will include the following...
Status quo – the current process for customers today
Incumbents – legacy players, who are already established
Direct competitors – other startups that are competing in the space
Alternatives/substitutes – completely different approaches to solving the problem
Budgetary competitors – other solutions that will compete for the available budget
This analysis also follows a 4 step process...
Research – look for companies that are solving the problem
Categorize – organize by key characteristics or points of differentiation
Reference – speak with companies and subject matter experts to learn more
Synthesize – build an opinion on the key factors that differentiate the competitors
This is an iterative process. You'll be repeating these 4 steps throughout building your thesis and speaking to different companies in the space. This should include both startups and more mature companies.
Once you've built your thesis, you should have a view on “what will win in the market.”
You may not be right, but you want to have an educated guess.
Step 4: Why now?
This is a really important step with venture capital investment theses.
There have been many great ideas and great technologies over the years that just didn’t have the timing quite right. They were a bit too early for their target market or the technology wasn’t ready. It happens all the time.
So, as you build your thesis, think about why now is the right time.
Here are a couple of aspects I’ll think through…
New technology – Is there new technology that has made this possible?
Customer behavior – Have customers changed the way they work or behave?
Regulatory environment – Have there been significant changes to the regulations in the industry?
To make this even more compelling, layer in evidence that supports this reasoning.
The more believable the narrative, the better the thesis. Not because it will be right, but because it will highlight that you can build a story for your investments.
Storytelling is a key part of venture capital and building startups.
Step 5: Provide examples, organize, and iterate.
As you build your thesis, find startups that fit the narrative.
I’d recommend aiming for 50-100 startups that fit your investment thesis. Organize these startups into different subcategories and highlight the best ones.
The more startups you find, speak to, and learn about – the better.
As you have these conversations, you’ll be able to test the underlying hypotheses of your thesis. You’ll learn more about the customers, competitive landscape, market opportunity, technology, etc. with each conversation.
Again, don’t be afraid to iterate and update your thesis. This is a constant work in progress as you gather information and learn more about the space.
Step 6: Prepare and share.
Finally, put your investment thesis into a memo, presentation, blog post, or some other format that can be easily shared with others in the space.
You can share this information with investors, founders, and other ecosystem players to build connections, develop expertise, and find great investment opportunities.
You now have specific value to add.
That’s it! A 6 step-guide to building an investment thesis.
Pick a problem
Why is this a BIG problem?
What are the current & future solutions?
Why now?
Provide examples, organize, and iterate.
Prepare and share.
