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…

More on Convertible Notes

I posted a couple of weeks ago on convertible notes and how I thought Angels were better off using them (Angel Valuations in Seed Rounds). I’ve realized that there were some inherent assumptions in that posting that I want to clarify. I’m prompted by a talk I saw yesterday where an experienced angel was discussing some bad outcomes he had had with bridge loans.

So I want to clarify. My posting was advocating the use of convertible notes in early stage deals, i.e. where the angel group (or individual angel) is providing seed funds or bridging to a first venture round. In those cases, I definitely think the convertible loan route is usually the way to go. There may be specialized exceptions, but that is a general rule.

The bad loans I was hearing about were much later stage loans. In one case, the loan was to a struggling company that already had taken in three rounds of money (i.e. had almost exhausted a Series C). They were running out of cash, and went to angels for a bridge. Presumably, their earlier investors were tapped out or disenchanted, but either way, the earlier investments were completely exposed. This is a “distressed company” bridge loan. Sometimes it is called a “pier” loan, i.e. a bridge to an uncertain destination.

I frankly believe this is an area where angels simply should not fly. Almost by definition, if the company can interest a Series D investor, there will be a major devaluation coming, and when that happens everybody is going to get a haircut. That kind of situation will even tend to select for a VC who is “bottom feeding”, and they are even more likely to not respect shallow-pocketed angels, even if the angel money is the most recent money in the deal.

It is a given that a seed-stage startup is distressed --- they have little beside an idea and sweat equity. But there is little to lose --- the valuation is hypothetical and somewhat arbitrary at first. The seed investors are in the same boat as the entrepreneurs, when facing the first institutional investors in a Series A. The Series A money doesn’t want to disincentivize the entrepreneurs, and the seed angels can shelter somewhat under that umbrella.

But later stage deals are cases where valuations have already been made, money invested, and positions have to be defended. These are circumstances where angels are ill-equipped to fight. This kind of defensive battle favors deep pockets and additional firepower. Most angels or angel groups are not good at deals that require repeated reinvestment. VCs know this and the knives will come out.

So I believe that in most seed and early stage deals, angels are well-advised to use a time-limited, escalating-return, convertible note instrument in their investing. And I further believe that angels should avoid getting involved in later stage bridge or “pier” loans in companies that have already been valued and are now likely to be revalued. In that case, I think angels should try to make any investment as a piggy-back on the new VC money, if they can get it, and not get out in front of that VC money. They will get run over.

An Alternate Investment Philosophy, Finding the Disruptive Deals

As I have mentioned in an earlier posting, I believe the nature and scale of many startup deals is changing. While VC funds are generally getting larger and the amount they need to invest in every deal is also getting larger, startup deals are generally requiring less capital to get off the ground. There is a disconnect here. I’ve noted that this is opening a window for angels. And I’ve just blogged that it may not all be good for entrepreneurs.

The Holy Grail for VCs is the big, hairy, disruptive deal --- an idea that completely upsets the playing field in a market area and allows for huge scaling and a big win for the investor. Think Skype, or Google (the ad company). How do you find “disruptive” deals, i.e. ones that can create 100x returns?

I am inspired by comments made by Nassim Nicholas Taleb in his most recent book, The Black Swan, The Impact of the Highly Improbable. He describes an investment philosophy where 80% of your capital is in lower risk, more conventional investments, and 20% is in smaller high risk investments --- trying to expose yourself to lots of possible positive Black Swans.

Now admittedly, he is talking about an overall investment philosophy from the perspective of a fund manager in NYC. But there is the kernel of a good advice here, I believe.

I’m suggesting that a VC fund should consider such an investment philosophy. The VC fund should set aside a specific seed-fund that is used explicitly to look for positive Black Swans. This seed-fund should invest in earlier stage or riskier investments, or to simply play hunches. The partner group should loosen their normal criteria when evaluating these deals. They should focus more on how disruptive the idea is. There may even be an opportunity to allow an individual partner to play a personal hunch. The decision can be made by just that partner, subject only to the outright veto by one of the other partners. I am proposing that that partner does not necessarily have to convince everyone to agree with their vision. And critically, in all cases, such a seed investment would have to be made with the expressed provision, at the fund’s option, to subsequently invest more, up to some limit.

Some Justification and Comments:

It is increasingly apparent that IT deals often need less capital to get off the ground. Also entrepreneurs are growing wiser about delaying a traditionally-scaled venture round until they have more traction. And angels are increasingly filling that gap. Early stage VC funds are prone to being "jumped" by deals that go from an angel round to a larger VC round.

Setting aside an explicit subsidiary seed fund and committing to try to invest it in more, smaller, more speculative deals will focus a VC’s attention on playing some educated hunches. I believe that the rational consensus-oriented approach VC funds currently rely on almost exclusively, leads to a more mundane set of moderate return deals and misses on the individual investment hunches of each investment professional.

One can assume the fund will see a larger attrition in these smaller seed deals, but even if they all fail the total amount lost would collectively only be equal to one or two failed conventional deals. On the up side, the fund may get a large piece of a more disruptive deal by grabbing a piece earlier. The result would likely more than offset these speculative losses, and maybe even “make the fund”.

Such deals would require some time commitment to mentor. Such mentoring and early support will build the fund’s reputation in the entrepreneurial community. More early deals may also come the fund’s way. It can be synergistic to their investment goals. And they learn by immersing themselves in some leading (bleeding?) edge deals that they otherwise would miss. The selection criteria for these deals might include a requirement that the team is clearly identified as “coachable”.

To put it simply, making seed investments from an explicit seed fund allows the fund to bet on more horses than they otherwise would and increases the chance that they’ll get a big winner.

This does not necessarily represent a relaxation of the fund’s investment decision standards. I believe that some of the best returning, most disruptive deals a VC may see do not lend themselves to classical due diligence and risk minimization. Sometimes it is a matter of connecting the right idea to the right people that unlocks big value. Doing more seed deals will allow the fund to possibly unlock more of these big opportunities.

Some deals are execution deals while some deals are big idea deals. I believe the current VC process tends to favor the former, but the big, hairy, disruptive deals with >10x return potential are more likely in the later category. Big idea deals don’t lend themselves to classical diligence.

Finally I want to acknowledge that Charles River Ventures has prominently taken a position that is similar to this idea. I’ve seen it stated that they are addressing the smaller deal demand issue with this plan. My point here is there may also be a greater yield in big idea, disruptive deals by making more smaller investments.

How close is Too Close?

A common axiom is “Invest in what you know.” I want to amend it. “Invest in what you know enough about… but not too much about.”

I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.

You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.

In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.

So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.

The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.

Startups Then and Now

A few years ago, I remarked to a friend that Microsoft Word took longer to start up on my 3GHz Pentium laptop than my DEC EDT word processor took in 1980 on a PDP-11/34 running RSX-11M. My modern laptop was hundreds of times more powerful, but I was still waiting 10 seconds. True, MS Word is much more powerful, but for the basic stuff, I was still waiting…

Nevertheless, when you read about productivity nowadays, it is apparent that in this decade we are reaping the benefits of the digital age --- all those computers and Internet linkages mean that the average information worker is much more productive today than he was just 20 years ago. In fact, according to the U.S. Department of Commerce Bureau of Labor Statistics, productivity in software publishing is up by a factor of 17x in the past 20 years. In Computer and Electronic Manufacturing, it is a factor of 9x.

So what does this mean to Venture Capital and startup financing? I submit that it simply takes less money to start a high tech company nowadays. Particularly in software development, the costs of developing a product are far lower compared to 20 years ago. And the reach of the Internet and the ease of leveraging viral marketing and messaging, means the costs of customer cultivation and product marketing and deployment are far lower as well.

I frequently see startup teams who have launched their company on less than $100K of total capital in, and only need $200-300K to get to breakeven. They can almost bootstrap it, if they use all the tools available to them, play the blogosphere right, leverage the buzz… Now it’s debatable whether trying to do it that cheap is always the best way to go, but it is certainly a viable option.

So one clear trend in my mind in seed venture capital is that deals are going to get smaller and VC funds are going to have to adjust to that. Six digit seed checks will become more common in the coming years, even with the effects of inflation. ($100K isn’t what it used to be…)

I actually believe that is healthy for the VC funds. As I’ve mentioned in my first post, I’m a big fan of Nassim Nicholas Taleb’s writings, particularly his most recent Black Swan book. He persuasively argues that a good way to invest in our inherently unpredictable world is, among other things, to expose yourself to as many positive Black Swan opportunities as possible, with a portion of your money. I think all VC funds would benefit from setting aside a portion of their funds, say 20%, and taking “fliers”, betting “hunches”, but most importantly making more, smaller bets. Yes, they can take up time, but I think it is manageable. And as Taleb says, your downside is limited to 1x, but your upside is largely unbounded.

The irony is most VC funds are going the opposite direction. They were so successful in the last decade that they have had little trouble raising gigantic new funds. When a partner group has to invest $1B, they are discouraged from making $250K investments. So they set a policy of investing no less than $5M in a first round investment, and reject deals that don’t “put that much money to work.” They say “your deal is very interesting, but it isn’t big enough for us”. In my humble opinion, this is a big mistake, and heading in the wrong direction.

VC funds, particularly those than do Early Stage investing, will necessarily have to evolve in the coming decade. This is a particular focus for me in this blog. More on this topic to come…

In the Beginning...

If I’m going to address the evolution of venture capitalism, it will probably help to first establish a context and starting points for this ongoing evolution. Starting enterprises is arguably the “oldest profession”, since the first prostitute probably needed seed capital to dress up for marketing to her first “sale”. OK, a poor joke… But in the modern era (i.e. the last 100 years) entrepreneur seed capital begins as angel behavior. At first you probably had to have money to start something new. You self-funded your new ideas. A good example might have been Thomas Edison. He made enough early money that he could afford to personally incubate ideas from his fertile mind. And he could borrow ideas from outside, improve on them and spawn another business. It’s my relatively uninformed opinion that this is how it gets started. Wealthy industrialists fund new ideas --- think Andrew Carnegie, Henry Ford. The seed capital comes from insiders and largely from themselves.

Wikipedia has a nice article on Venture Capital. It seems to suggest a second source of seed capital that it doesn't call out explicitly, e.g. the government, especially during extraordinary times such as WWII. The military had to create industries and suppliers from scratch to meet its needs in major defense projects. Think about the creation of atomic weapons, and all of the various components and materials that had to be created from out of the blue. General Leslie Groves was effectively a venture capitalist with a bottomless Limited Partner in Washington.

Wikipedia credits General Georges Doriot as the father of modern venture capital. My guess is that he got the idea from his experience in the wartime years, where the audacity of the military meant starting things from scratch under duress. Doriot was clearly a well versed business professor, having taught at the Harvard Business School, but I’m guessing it took the audacity of war to break through to the idea that you could start a company entirely from scratch, and do this as a repeatable business.

So we begin with wealth, expansive thinking, audacity. This is an angel dominated world. Wealthy people spending their money to make them more money and expanding their legacy. But in my mind, modern venture capital begins when you have professionals investing other people’s money. This seems to first happen with Venrock Associates, which starts as a group of professionals investing the Rockefeller fortune. Laurance Rockefeller starts it off, but he quickly hires pros to manage it.

Frankly this is the beginning… a couple of senior management types helping their boss, Rockefeller, to be a better angel investor.