Sunday, December 16, 2007

Who are those guys? What makes a good VC. Episode 2

In my last posting, I laid out a framework for identifying the skills that make a good VC. I did it roughly chronologically, from finding deals to exiting them. I divided that process into 5 steps as follows:

1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit

I then analyzed the work a VC does in step 1 and the skills that make one VC better than another.

In this posting I’m going to tackle step 2, i.e. Evaluating and Picking Deals to invest in.

I must confess, as an aside, that I have in the past week received my preliminary full gene analysis from an unnamed company. It has been very distracting and kept me from getting to this next posting. Sorry for the delay. I’ll probably post something on my genetic explorations in the coming weeks.

Step 2: Evaluating and Picking Deals

The VC business is a sifting business, as I have commented before. It is like hunting for pennies in your coin jar. Step 1 was about getting as many pennies in the jar, ideally as many promising pennies, as you can. In this Step 2, the VC is going through the jar trying to find the most valuable ones.

What is involved here? An entrepreneur has submitted a plan summary to you and you are reading it. Or an entrepreneur is meeting with you and walking through a powerpoint deck and maybe giving a demo. The VC has to decide which deals to give more attention to. As I have commented on in an earlier posting, the VC business is like being at the end of a fire hose. There are so many deals, and so little time. So there is a premium placed on time management and a VC has to make quick, decisive calls to protect his/her time.

So the first skill I want to emphasize is decisiveness. Every deal wants to get financed --- every doll is wearing her best makeup. A good VC has to make an early decision as to whether this is a deal that is likely to lead to an investment. If it isn’t, or is very unlikely to, then a good VC will make that decision and move on. (Ideally, that will be conveyed to the entrepreneur in a constructive and polite fashion. Otherwise they will soon see less Step 1 deal flow.)

Now to make that early decision, a VC has to have some domain expertise in the market area being discussed and the technologies and incumbent competitors currently addressing it. Therefore, a second skill is domain knowledge in one or more market areas. Here there are arguably a range of approaches. Some VCs have a moderate domain expertise in a larger number of markets. Other VCs are deep domain specialists who generally only focus on a narrow spectrum of deals. I think it can work either way. I have commented in a past posting that I think it is possible to have too much domain expertise in an area, and therefore be blind to revolution, or biased against it, when it knocks. But if a VC can make their whole living investing in an area they know intimately, then why move out of that sweet spot.

But I do believe that it is important for a VC to have a fairly broad grounding in technology, at least in the high tech VC world I work in. Even if you have deep domain expertise in one area, often a revolutionary idea can come out of left field and it helps to have a broader technology foundation so you can perceive it when it comes.

A good VC is also a good judge of people and character. Do these entrepreneurs have the personality, ambition, expertise and experience to make this startup a success? You have to try to size this up quickly, often in one brief meeting. Given the fact that entrepreneurs have to be just a bit wacko to try to start a new business and knock off a bunch of better positioned incumbents in the process, judging whether they are investible, and just crazy enough, can be challenging.

If a deal meets the basic criteria, and has captured the VC’s interest, the next step is to investigate the deal further, validate the entrepreneur’s assertions, verify the market and its acceptance of this startup’s offering, and confirm the technology and its uniqueness and protectability. I would submit that another skill comes into play here --- a disciplined and analytical approach to problem solving. I think the best VCs try to identify the deal-breaker aspects of a deal and try to focus on them first. This is about time economy and responding to that fire hose problem. A poor strategy is to validate the easiest stuff first, i.e. get comfortable with the least risky parts of the deal and start to “fall in love” with the deal, before you have confronted the most critical issues. In the most extreme situations this can lead to an intellectual logjam, where the VC has been seduced by a number of easily validated aspects of a deal, has invested a fair amount of time in the deal, and then is less receptive to critical weaknesses that are identified later. I think they can get stuck at “maybe”, and then reluctant to say no.

So I believe the best VCs are skilled at zeroing in on the major risk factors that are deal breakers, and clearing them or calibrating them first. They don’t tackle the diligence process in order of ease, but in order of criticality. This requires clear analytical skills and discipline in execution.

Another advantage a good VC often has is a large “rolodex” of past associates and friends that he/she can call on to get an expert opinion from. The best VCs have huge rolodex’s, and they work to enlarge them. They add their investment portfolio management to their lists, especially the successful ones. A lot of the sifting process is one of networking with better informed minds on a deal.

And good VCs are a little cheeky --- they will be able to pick up the phone and cold-call a key source for info. It is never a good idea to let the entrepreneur sequence the investigation. The entrepreneur will always try to focus you on their good aspects. A good VC thinks independently, identifies critical risk factors, clears or values them upfront, and leaves the window dressing until later.

Finally, this deal evaluation and sifting process is going on in parallel for a large flow of raw deals, and a handful of deeper dive deals that have passed first muster. A key skill is the ability to keep a lot of balls in the air and be able to shift contexts on a moment’s notice. In my experience, a typical VC may have 20-30 deals in his head at any one time, may know a lot about 5-10 of them, and may be nearing a key final decision on 2-4 of them. And remember, that VC is also probably on a half dozen boards and providing key support to those companies as well.

The goal of the first step was to add as many good deals as possible to the top of the funnel. The goal of this second step is to manage the funnel process, whittling down a vast number of deals to the ones the VC wants to make a run at. It is about time management, efficiency in the use of attention, perceptive identification of risk factors, disciplined understanding or control of those risks, and judging whether the entrepreneurs can pull this off and make the fund a respectable return.

In summary, the skills needed in this second step are discipline, independence, confident cheekiness, analytical thinking, good domain and market knowledge, a broad technical foundation, decisiveness, good people instincts, a large backup network of people to call on for advice, and an ability to juggle many deals and contexts. (And let me add one more: a good bullshitometer --- every VC sometimes sees a deal where the spiel is just too good and you instinctively say something is wrong here. In my experience, it is often best to just walk right there, and save yourself the time.)

This sifting process is not perfect. Many good deals are sifted out, and every experienced VC has heard of or actually turned down deals that later were huge successes. But VCs are measured on how well they return to their LPs, i.e. how good the deals they chose did, and not on whether they turned down winners.

Next I will cover the key step of crafting and executing a deal.

Now back to my gene pool…

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