3 Reasons Why VCs Have Scouts

In the industry of deploying capital, alpha comes in the form of power laws. Power law refers to a single investment that yields returns larger than all of a venture firm’s other investments combined. Power law exists all around the world. There are a lot of them in Silicon Valley, some in India, Japan, South Korea, and other regions.

The point is, they are everywhere because more people have started founding companies in different cities than ever before. The collection of power laws amplifies returns to LPs, but spotting asymmetric bets (startups) is tedious. To be frank, venture firms cannot open shop around the world - it’s too costly and honestly unnecessary.

Bring in scouts, and it suddenly looks like venture firms are equivalent to a multinational corporation. You speak to someone in Europe, and they may tell you that they scout for a16z. Speak to someone in Southeast Asia, and they might say the same about Sequoia. One of the venture firms that leans heavily on scouts is LvlUp Ventures. I scout for them, and have spoken with founders building in different regions. Golden Goose, Carro, and Versus are some companies within LvlUp’s portfolio with high valuations. They are not all US-based, but they are a US-based venture firm. Speaks volume to how a broad network compounds access to asymmetric bets.

This should set the direction of the article. Other than cost and tedious work, venture firms partner with scouts for three profound reasons. As a scout and someone with prior venture experience, I’ve come to understand three main reasons why venture firms partner with scouts.

3 Reasons VCs Partner with Scouts

If you have read The Tipping Point by Malcolm Gladwell (highly recommend), you would be familiar with the term Connectors - people who seem to know everyone, moving effortlessly across different social worlds and linking them together. In the context of scouts, they are individuals who are very well connected either through their personal or professional life, with an exposure advantage to the builders (founders). This should establish the fact that they are the eyes and ears of a venture firm.

But how does this network effect work in practice?

I. Venture firms have more deal flows. With more deal flow, they get to invest in more startups as long as it fits their thesis. It has become a fact in venture that diversifying across industries raises the odds of landing a 100x return. Diversification matters in startup investing, too.

Before that, a little caveat:

Let’s retrace to

“It has become a fact in venture that diversifying across industries raises the odds of landing a 100x return.

To be frank, venture firms are not all sector agnostic.

Ribbit Capital has proved this. They invest exclusively in fintechs. Some of their notable investments include Robinhood, Coinbase, Nubank, Affirm, and Brex.

Now, back to the network effects.

Imagine you are a GP with scouts in different geographic locations, or maybe your scouts brought in more startups that even your personal network wouldn’t be capable of connecting you with.

How do you think that will help you?

a. Valuations will differ based on different geographic locations. Typically, valuations are lower in emerging markets than in Silicon Valley. You get to make more calculated risks. Here’s a graph that depicts valuations across different regions:

b. You get to see deals earlier. By the time a hot startup reaches your inbox, it’s often already been shopped around. A scout will flag that startup while it’s still a rumour, before the round gets competitive.

c. Your startup diversification becomes concrete, not a dream. When you have a scout on the ground in a specific region, you will have someone reliable to work with the startup and monitor their progress. Your scout becomes the trust layer.

II. When you have a massive pool of startups to evaluate, you get to make a more sound decision. You probably would have comparables within your deal flow that you get to choose the startup with a better team, product, or financials.

The ceiling here is the network of GPs and LPs. Scouts make the ceiling infinite.

Now, onto the second reason.

As much as diversification matters in startup investing, timing does too. Investing in pre-seed is widely known to provide explosive return potential. To understand why, you should look at how the startup’s price tag changes over time compared to the risk it’s exposed to. Two curves that move in opposite directions clearly explain this - the risk curve and the valuation curve. When a startup is founded, its valuation will be low. As it starts hitting its milestones, its valuation starts climbing upwards while some risks starts trending downwards. By the time it raises later rounds, the price of buying a piece of that company increases.

Here’s a graph that shows the relationship between valuation and risk:

But, risk and valuation don’t move at the same pace. For example, if a startup’s valuation rises to $10,000,000 between pre-seed and a Series A round, the actual operational risk of the startup doesn’t decrease by that same factor. By investing at the lowest stage of the valuation curve, you get a massive discount.

Why?

You are accepting a higher risk in exchange for a price that is exponentially cheaper, creating a more favourable risk-reward ratio. Remember, GPs have to cover legal fees, operational costs, and other expenses while returning the fund with a profit to their LPs, so it only makes sense to have exponential returns.

Let’s move on.

The startups that get referred by scouts come with part of the due diligence already done. Scouts are at the forefront of founder circles - they know who ships and who just talks. By the time the founder is introduced to the venture firm, they have already been quietly vetted on character and execution - the parts no data room can reveal. Capital cannot buy presence, but scouts can provide it. For example, a GP in New York can’t spend years observing a founder in Tokyo, but a scout probably already has. As a result, deals move faster because trust has been built - only capital has to be deployed.

Did you know that Sequoia pioneered the scout model? Jason Calacanis, one of the four besties from the All In Podcast, used his Sequoia scout allocation to make a $25,000 bet on a little-known startup called Uber Cab. That stake grew to over $110,000,000 within five years. Fun-fact of the day!

So, who should venture firms partner with? I think the best scouts are current or past founders, ex-venture capitalists, and operators at startups because they are or were at the forefront of the exact problems, teams, and technical shifts a fund is trying to spot early on.

Now we know why the eyes can’t see everything. Information advantage and capital alone are no longer enough. Alpha is produced through an expanded network, an early entry point, and a trust layer.

I hope you enjoyed reading this. See you in the next one!

Are you fundraising for your startup? I scout for LvlUp Ventures. Book a call with me here, and I will further explain the process.