Naval: Social proof only works when the actors are independent and it matches up to your diligence and conviction. Then social proof can be a clincher, filling in gaps in your knowledge or helping you figure out when it’s time to stop waiting to exercise an option and close the deal. Social proof cannot be the sole determinant for investing.
Learning how to read the signals around social proof is an art form. For example, when a big VC invests in a company, ask yourself: Is it a meaningful amount for that VC? Are they increasing or decreasing their percentage ownership? Even though they’re investing, their ownership in this round may be going down because other people are putting in a lot more money. Perhaps the VC’s only putting in the bare minimum needed to bring in more capital.
The ultimate social proof is a credible VC increasing their ownership stake
The ultimate social proof is a credible VC investing an amount of money that’s meaningful to them and, ideally, increasing their percentage ownership in a company.
The cleanest signal an investor can send is investing their pro-rata. If they put in less than their pro-rata, especially when the investor has deep pockets, that implies they’re losing faith in the company. If they invest more than their pro-rata, that implies they’re being greedy with their ownership—and that’s a very positive sign. Although, at that point, why would they even share the deal with you?
You also have to check for conflicts of interest. When a founder invests in their own company, the signal matters a lot less. The same is true for the founder’s relatives and anyone who got advisory shares or a special deal.
VC firms sometimes invest in deals just to buy options
When a large VC firm invests a meaningful portion of a round, sometimes they’re just buying an option.
For example, a VC firm putting in half of a company’s $1M round may not be the social proof you think it is, since it isn’t a meaningful amount of money to them. The VC may be planning to turn over another card: If the company succeeds, the VC will be in a pole position to get the information early and put in $50M, which is where they really make their money.
The VC might be buying an option, but you’re trying to buy an investment. So you’re operating on different terms.