While to an outsider it might seem like some venture capitalists choose the sector they are going to invest in by throwing darts at a dartboard, the reality is that picking a sector is much more complicated, and calculated, than that.
In fact, the best VCs typically treat the process in much the same way that entrepreneurs manage their market selection process. We look at such factors as opportunity and competition, and whether or not a particular sector’s dynamics are pushing the market upward and creating significant momentum. From there, we can place an educated bet on those sectors that we believe are most likely to yield returns for our investors.
More specifically, I’ve seen VCs use four common methods for selecting the markets that they invest in:
Being opportunistic: Of the countless companies that come across an investor’s desk each year, many are in sectors that the investor may not have ever considered before. Smart investors try to get a handle on the growth dynamics of those sectors to see whether or not they are indicative of a larger opportunity across that entire category. That growth may warrant a deeper dive into a specific sector to identify any other opportunities that exist.
Spotting trends: This method isn’t too different from the one above, but it typically takes a few other factors into consideration. Namely, it involves looking at the trending sectors that the VC’s peers or counterparts are investing in. The idea is that VCs don’t like missing out on big upward market spikes. As a result, they often keep tabs on the sectors that others are heavily investing in to see if there’s an opportunity they are missing out on. This method can be a dangerous game to play, however, because getting caught up in the “me too” approach to investing can be a slippery slope. Sure, a VC may hit a home run in a sector that’s on fire, but it might also make an ill-advised investment in an attempt to simply jump aboard an already-crowded bandwagon.
Conducting intense research: Unlike the previous two methods (which often depend to some degree on instincts), this investment approach involves picking a sector and diving deeply into it to understand market dynamics, drivers, and players. That means speaking to a lot of entrepreneurs, category analysts, and industry experts with the goal of uncovering data that can be used to identify the most interesting sub-segments within that sector. From there, VCs can evaluate those segments to ensure that they are picking the right ones.
Relying on experience: If a VC has been around for several years, its team likely has an acute sense of which sectors it has had success in in the past as either investors or operators. In these scenarios, the VC may simply count on that experience and its networks to identify which markets to invest in. By leveraging that domain expertise, investors are often able to quickly decide if a market and company are worthy of their time and money, and will also be more likely to win the deal.
Of course, not all investments originate with a consistent methodology (or a strong market thesis, for that matter). In fact, many VCs identify potential investments through their own networks and relationships, while others sometimes rely on good old-fashioned luck.
That said, establishing a viewpoint on a sector allows us to:
— Decide if it’s one we really want to invest in so that we can quickly move toward a decision
— Convince other partners within the firm to see the potential in (and challenges of) a particular sector
— Build a network of market experts who can be helpful in evaluating current and future sector opportunities
— Select the right business within that sector to invest in
Truthfully, identifying good markets to invest in is never easy for VCs, and there’s a certain degree of risk (and luck) in every investment decision.
Fortunately for VCs and entrepreneurs alike, markets are always changing. With new entrants, advances in technology, and shifting priorities, what may have been an uninteresting market five years ago may very well be an exciting market today. Identifying (no matter how you do it) that market opportunity early is critical to both an entrepreneur and investor’s long-term success.