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…

Who are those guys? What makes a good VC.

I want to begin to tackle my original topic of interest, i.e. where is the VC business heading in the coming decades. I thought I'd start out be defining the tasks a VC performs, i.e. what skills make one VC better than another. The fact is there probably is only one ultimate measure of a VC that counts --- return on invested capital. I’m not trying to dispute that. But what are the characteristics of a VC that will lead to a good return in the end?

I’m going to organize this somewhat chronologically through the process. And I’m focusing on skills and tasks along the way. Here’s the outline:

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

One can assume that focus, intelligence, integrity, fairness, responsibility, and good communication skills --- these are all valuable and assumed across the board. Finally, I have no gender biases and will use the male gender for simplicity. A female VC can certainly be as good or better than any male VC.

In this first posting on this thread, I’m going to address just those Step 1 skills. Other steps will follow in succeeding postings.

Step 1: Finding Deals

For a venture fund to be successful, it must have a rich deal flow. Garbage in, garbage out… as the saying goes. And every deal presents a different mix of characteristics. The fund needs to see lots of possible deals, ideally all with the fundamentals in order: solid management, strong technology, addressing big markets and with barriers to entry. There is no such thing as a venture fund that invests in every deal presented to it. The venture business is a sifting business. The better the selection, the better the investments that will result.

Therefore a successful VC must either a) get a lot of deals referred to him by colleagues in the field or past associates, OR b) get out there, see a lot of deals and maintain a high profile.

In subcategory a) are those VCs who have a great deal flow coming to them naturally by referrals --- I believe these are rare birds. They are usually extremely successful VCs from the most prestigious funds. We all know a half dozen names of superstars in the field. The best deals frequently come directly to them. That is a result of their success up to now, not the cause of it. Sitting back and waiting for the deals to come to you isn’t something to emulate. I do acknowledge that some superstars are surrounded by a great support staff who often go out and do the legwork for them. But I’m talking here about how you become a superstar, not how you act after you are one.

The second subcategory b) “get-out-there” path favors a personality that is friendly, helpful and engaging. It definitely does not favor arrogance or reserve. Entrepreneurs are more likely to want to work with VCs who are approachable and mentoring. Unfortunately, the VC community often draws its players from the most successful leaders in business and these are frequently very egotistical people. In my opinion, this is counter-productive to getting a good deal flow.

Ironically, it takes a lot of self-confidence to invest millions of dollars in a deal where the team is young and imperfect, the technology is new and unproven, the market doesn't even know it's a market and the incumbents in the market are big and powerful. That favors aggression, competitiveness, and single-minded focus in a VC. In other words, it naturally pulls a VC's personality away from what I think are key skills to this stage in the investment process.

Nevertheless, I believe the key skills for a VC are to be visible, approachable, helpful and mentoring. It is possible to hold these skills and still be self-confident and focused. As an aside, I think this also favors former entrepreneur VCs over professional MBA VCs. A VC can be most helpful from a position of shared experience. Entrepreneurs will appreciate that experience.

So I would argue the best VCs are confident, polite guys, who relate to the entrepreneurs out there, who do lots of panels and presentations, are accessible, listen well, and contribute more than just occasional funding but also advice to entrepreneurs. A VC who does all these things, and does them well, will see more and better deals.

Summary Skills for Step 1: Accessible, open, helpful, visible, mentoring, confidence without arrogance

(To be continued)

Angel Deal Types

I’m involved with three different angel groups, and often guest at the meetings or screenings of two others. I see a lot of deals in the screening process for these groups. It seems these deals fall into four general categories:

1. Low Capital Requirement Deals. Deals that don’t need a traditional, venture capital-sized investment to get to cash-flow breakeven. These are capital-efficient deals that can get to revenue early, and boot-strap themselves through the growth stage. In today’s web x.0 world, I think these deals are more common than ever (as I have blogged previously). And I think they benefit from a particular kind of angel investor, i.e. one who has a more active hands-on approach and plans to mentor the deal and team more. These deals are unlikely to raise or even need follow-on VC investment and get a more experienced and connected board later. The mentors they pick up in the angel round may end up being the guys they use as advisors throughout the history of the company. These are not “fire-and-forget” angel deals. And they may make more sense as simple priced, preferred stock deals, rather than convertible debt deals that I have advocated in previous postings.

2. Seed Deals. Deals that need seed capital to address some early risk factors prior to seeking their first formal venture capital round. The idea is to reduce those risks so they can get a better valuation from their first VC round and experience less net dilution. Frequently, a valuation inflection point is only an angel round of seed investment away. It may be to build a proof-of-concept model, or launch a beta test, or stabilize and add to a thin development team. I think deals in this category are more common in areas like the Bay Area where there is abundant VC funding. And this is the kind of deal where I think a convertible debt deal with a discount or warrant, and an escalator for delay in conversion makes the most sense.

3. Failed To Raise VC Money Deals. Deals that have tried and failed to raise their first funding round from conventional VCs and are “moving down the food chain” to Angel Groups. These deals normally have very tenacious founding teams who aren’t taking no for an answer. Often they revise their pitch to reduce their capital needs so as to appear more angel-friendly. In some cases this may make sense. If they were naïve at first and underestimated the impact of their risk factors on the VCs, they may have come up dry. They may benefit from converting to category 2 Seed Deals described above. The logic is “Raise less money, address your weak points, and then go back to the VCs.” Unfortunately, I see a lot of deals in the angel world that aren’t like this. They are simply failed venture deals. Frequently, they are failed VC deals because of team problems, or IP issues. They still have high capital requirements and are inappropriate for angel investment. There is an irrational aspect to starting a company, and slightly irrational entrepreneurs can assume that a lot of turn-downs simply means the VCs don’t get it. And angels may not look as deeply or be as experienced investors. A good story may snag an angel where it wouldn’t convince a VC.

4. “Bridge” Deals. Deals where a company has already successfully raised a previous round or rounds of money, has burned through that money and the existing investors are now disenchanted and no longer interested in follow-on financing. The entrepreneurs are trying to repackage the deal, spin it a different way, “put lipstick on the pig” and sell it to the angels. The entrepreneurs in this case may be reasoning that angel groups are less likely to come at the deal with knives, i.e. to force a down round. Angels may be more gullible. The entrepreneurs may position this as an opportunistic chance for the angels to bridge the company to its next “inevitable” venture round. As I have said in a recent posting, this is very dangerous ground for angels to be investing in. Failed startups that are back looking for new money from angels in a distressed condition, will very likely “experience the knives” eventually. The capital capacity of angels is unlikely to be able to fix what ails that kind of company. Angels who play in this category had better be experienced bottom-feeders. This is a special and dangerous world.

No doubt there are other more specialized categories, and admittedly, some deals won’t fit neatly into one of the above categories, and may have aspects of more than one.

An important question for angels to address when seeing a new deal is which category does this deal fits into. In my humble opinion, angels and angel groups are best advised to invest in the first two categories, i.e. deals that are clearly within the capital reach of angel money (category 1), or deals where the angels are effectively becoming cofounders and helping position the company for its highly likely first institutional round under fair economic terms (category 2). I believe angels should avoid deals that have been extensively and unsuccessfully shopped to VCs (category 3), unless they can see a way to turn the deal into a category 2 deal. And I believe angels should avoid deals (category 4) where VC’s have already played and are now absent. “There be tygers…”

Entrepreneurs are just a bit irrational --- they have to be to start a company from scratch. I know. I’ve been there multiple times. They will say what they need to to get funded. They will alter their story to make it seem angel-friendly.

Angels and angel groups are usually seen as the farthest out-there on the money tree. They will tend to naturally see the earliest and rawest deals, or the most desperate deals. It is best for angels to first try to separate the deals they see into early vs desperate piles. Highly motivated entrepreneurs are great; desperate, back-against-the-wall entrepreneurs can be a lot of trouble. Then focus on whether you want to back a deal with a few other angels, or as a precursor to bigger investment by VCs.

My two cents…