Who are those guys? What makes a good VC. Episode 4

This is my fourth installment where I’m trying to define what makes a good VC. I have broken the task into 5 stages or episodes as follows, and I'm tackling each stage in turn.

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

The previous three stages are earlier posts below. This is stage 4, where I am talking about the time after making a venture investment and building value in the startup, in preparation for an exit. This is the operational part of the job --- how do you help a startup succeed? I should disclose in advance that I am a believer in venture capitalists who are actively involved with their companies, who require board of director roles, and who keep in frequent touch with the startup team. There are VC funds that function as silent, hands-off players and follow other investors leads. The following really doesn't apply to them.

In my humble opinion, the best VCs are those that have an operating background. Starting a company presents the entrepreneur with a range of complex problems and decisions that have to be made. The best VCs are ones that have confronted these issues in their own careers. For example, a balance has to be struck between frugality and audacity. A thrifty startup fosters a healthy company culture and focuses the majority of spending on areas that increase the value of the enterprise and the likelihood of success. On the other hand, knowing when to hit the accelerator and spend the money for the greatest effect, that is a challenge that every entrepreneur faces. It really helps to have backers and VCs who’ve done that before.

And there are a host of seemingly minor administrative decisions a startup needs to address, e.g. payroll, benefits, facilities, accounting, legal, IP protection, capital equipment, hiring… Experienced entrepreneurs have encountered these issues in their past startups. They make the best VCs in my humble opinion during this stage.

One key challenge is transitioning a founding team into a management structure that can grow the business. Frequently, founding team members “get ahead of themselves” and get set on how they are the right people to lead this venture to the promised land. They see themselves as the next Scott McNealy or Steve Jobs, i.e. the founder that took the company all the way to billions in revenue. Or a cofounder has gotten comfortable with a lofty title and responsibility area and doesn’t want his role reduced or narrowed. Or the founders have brought along one of their fraternity buddies as a co-founder, mostly because he’s a long-time drinking buddy, but who has no qualifications for the job he envisions for himself.

A great stage 4, “operating” VC will be adept at building a sensible and scalable management structure from the founding team, without disrupting the operation or culture of the startup. Almost more importantly, a good operating VC will mentor the founding team members so that they see and buy into the wisdom of this management structure.

This is one of the most challenging aspects of investing in and helping manage a startup: managing individual egos and expectations to maximize the overall value of the enterprise. By definition, to have the courage to start a company from nothing but an idea requires a big ego and almost an irrational determination to succeed. But the VC is investing in the overall enterprise more than the individual egos of the founders. Sensitively managing those egos for the overall benefit of the organization (and everyone's investment or time or money) is a truly important skill for a VC at this stage.

Another key value that an operating VC can and should offer to a post-investment startup is introductions to key contributors, i.e. partners, customers, key hires, etc. That means it is important for the VC to have a full rolodex, which again favors VCs with long operating histories.

Perhaps the hardest to quantify but ultimately most important addition a good operating VC can offer to a startup team is rational and reasoned advice and criticism on strategy. An operating VC in this stage, typically also serving as a board member, is ideally suited to give the entrepreneur advice that is not biased by the day-to-day "drinking of their own Kool-aid" that an aggressive startup team may suffer from. A great operating VC can give the team perspective and balance, at least partly from an outsider’s perspective at those monthly or quarterly board meetings, and intervening contacts.

Finally, once a VC is invested in a startup, one of their key tasks is to bring in follow-on financing and new venture capital firms to lead those rounds. That means coaching a startup team to do a great venture presentation. It is ironic that now the VC is coaching the team on how to best sell their deal to other VCs. But it is further ironic that VCs are often particularly good at this coaching. They see lots of deals and they know a good pitch when they see it. They know what sells THEM on a deal. But a great VC can often help an entrepreneur position their deal relative to all the other competing deals out there that a follow-on VC might be seeing.

So to summarize, in this stage a good VC is bringing operating experience, mentoring, a good rolodex of contacts, team-building and human resource skills, strategic thinking, a balanced “semi-outsider’s” perspective, and coaching on how to best raise more money.

Who are those guys? What makes a good VC. Episode 3

This is the very belated third installment of my running saga about what makes a good VC. I have previously laid out a framework for identifying the skills that make a good VC, in rough chronological order through the process. Each installment covers a stage:

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

So here’s stage 3, a discussion of the skills involved in executing an investment that make a good venture capitalist.

This is the stage where the rubber meets the road. The previous two stages were window shopping. Here the VC is buying. The VC’s goal is to buy a share of the startup at the best possible price in return for his investment capital. But it isn’t quite that simple. For that investment to actually pay off, the VC needs to incentivize the entrepreneur and help grow the business. It is a very rare business where a VC can add funding and any idiot can turn it into a large multiple. First, there are no certainties. Second, every startup needs motivated, intelligent people to grow the business and realize a big increase in value. Finally, pretty much every startup entrepreneur needs experienced advice and critical contacts to fully realize that big increase in value.

So a good funding deal is one that leaves everybody incentivized to grow the company. If that doesn’t happen then everyone will equally share the loss. A VC who drives too hard of a bargain, and leaves the entrepreneur with too little of the upside, risks undermining the founders’ determination to put everything into the business. On the other hand, a VC who puts too high a value on the premoney of the startup, and therefore takes too small a share of the ongoing profit, will not last long in the competitive VC world. Further, they may make it harder for the entrepreneur to attract further investment in a later round by unreasonably inflating the entrepreneur’s expectations on valuation.

The entrepreneur is at a disadvantage. They are lucky to have a buyer. In contrast the VC sees plenty of deals, dozens a week, and will only fund less than 1% of the deals he sees. And there is the “golden rule”, i.e. whoever has the gold makes the rules. Only very rarely does an entrepreneur have exclusive control of such a disruptive idea that they can dictate terms to a host of VCs. Usually, the VC sets the terms and the entrepreneur can only improve them by generating some competition for their deal. And VCs will usually work happily together in a syndicate, and tend to know each other in their focus areas, so even the competition strategy can be hard to execute.

I’m arguing here that a good VC is thinking about the long term success of the deal, and not so much about extracting the maximum amount of benefit for his fund. In most cases, a deal has a limited number of bidders who are focusing on that market area and could fund that deal. But I believe the VC who “sticks it” to the entrepreneur because he knows he can, because the entrepreneur needs his money more than he needs their deal --- that VC is really undermining his own chances for a long term success. The entrepreneurs need to have incentive to give the business EVERYTHING they’ve got. A good VC needs to strike that balance.

So a first key skill is balance and fairness, finding that right mix of founders’ incentive and investors return.

Another important aspect of getting a funding done is crafting the terms of the investment to fairly cover all of the eventualities. A termsheet is often filled with pages of clauses that attempt to cover every possible outcome. There is a lot of technician work here that is often based on hard experience by the VC or by their attorneys. VCs do carry an advantage in this phase, because they do a lot of termsheets and their attorneys are specialists in this phase. In contrast, many entrepreneurs are seeing a termsheet for the first time. True – they will hopefully also be represented by experienced attorneys, but the nature of the venture capital business is that only a minority of startups actually get financed, and even fewer have multiple financing options in front of them.

So another skill set (or maybe it is better described as hard won experience) is the ability to see all of the possible outcomes in a deal and anticipate them in the funding documents. When something happens downstream and it is completely unanticipated, that is usually a place where things will get ugly. It is better to try to anticipate even unlikely outcomes and try to agree in advance how they will be handled. Since most VCs have experience with failed companies, they are again more experienced here, compared to the entrepreneur. In fact, entrepreneurs are generally selected for funding because they DON’t have a lot of failure experience. But the nature of high-risk venture investing is that many (even most) VC deals will not turn out as planned. A competent VC knows the downsides.

My goal in this posting is to further explore what it takes to be a good VC. I’m not going to delve into the details of termsheet construction. But creating a fair, balanced and comprehensive termsheet is a key skill for a good venture capitalist.

There are also related skills in getting the deal done. Being able to reach out to syndicate partners where needed, and ironically to become the deal advocate, this is also an important skill. VCs often need to be able to “sell” as well as “buy” at this stage.

Also, a good VC needs to gain the confidence of the entrepreneur who is ultimately going to be his partner if the deal is consummated. It can be very challenging for a VC to gain the confidence and trust of an entrepreneur, while simultaneously pricing his deal and imposing all these arcane terms and worst-case scenario constructions on the deal. So I believe another key skill-set is to be a good communicator and negotiator.

So to sum up this episode 3, “Doing the Deal”, I think the key skills of a good VC are balance, fairness, experienced anticipation of downsides, communication, negotiation and openness that engenders trust in entrepreneurs. One must never lose sight of the fact that a VC is only successful when the startups he/she invests in are successful. Any behavior by a VC that hurts the chances that a deal will be successful is counterproductive and plain stupid. VCs must be ultra-confident to throw their money and reputations at completely unproven startups. Ironically, that ultra-confidence can easily lead them to be overly aggressive “cowboys”. Such behavior is ultimately not in their best interest if it disincentivizes their entrepreneur or scares off syndicate partners.

In the next Episode, the VC and the Entrepreneur are now ostensibly in the same boat, working toward the same end. We’ll see…

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…

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.