Tag Archives: Venture capital

Prioritizing startups to evaluate

There are many more small companies trying to grow big than large and relatively established companies. As a result, venture capital (VC) investors who invest in small companies with the potential to grow big are seeing many more companies at any given time than private equity or public equity investors who invest primarily in large and relatively established companies.

However, there is a natural limit to how many companies you can evaluate in sufficient depth to develop an informed view on these companies at any one time. For me this is no more than 3 companies at any given time. For others it may be slightly less or slightly more. However, there is a limit.

In order to manage the large number of companies that you can potentially evaluate as a VC, you need to do two things.

First, you need to get comfortable with saying no very often. If there are clear red flags regarding an opportunity, dismissing it at the outset is necessary to save your time to evaluate those opportunities that you find more promising.

While you might be mistaken and miss out on a big future success, not doing so is more costly as it leaves you with less time to evaluate those companies that you believe are much more likely to become big successes. The more startups you’ve seen, the better your intuition about what is likely to develop into a big success becomes, so the higher the cost of not trusting that intuition.

Second, among the companies that you decide to evaluate in further depth, you need to keep a running list (I keep an actual written list but this can also be a mental list) where you change the prioritization of, add, or drop startups as you do more research into each company and as new opportunities arise. Although there may be 5 to 10 interesting companies on your list, you can only properly research and deeply think about a few (in my case 2 to 3) of these at any given time.

The rest just have to wait, even if this means that you miss out an a big future success. With experience and the pattern recognition that comes with it, the likelihood of this happening will fall over time.

Making your reputation on the ones that don’t work

Venture capital is a private asset class that has a greater global supply of dollars than great startups where those dollars can be put to good use. The private and globally oversupplied nature of venture capital (there are pockets of undersupply in some emerging markets like Turkey) makes seeing and getting into deals as important determinants of success as the exercise of sound judgment when evaluating companies.

And seeing and getting into deals is not only a function of the success of the companies you invested in in the past, but also your reputation in how you dealt with these companies.

Your reputation, in turn, is at greater risk when things go wrong than when things go well. The reason is that, in the former, there’s more to correct, including that which often requires stepping on some people’s toes, as well as more blame to go around.

That’s why I really like this quote from Andreessen Horowitz’s Marc Andreessen:

“We make our money on the [startups] that work and we make our reputation on the ones that don’t.”

Conversational culture at VC firms

Success in venture capital requires being very good at making qualitative assessments while being good enough at making quantitative assessments. The reason is that startups tend to have limited operating history and hence limited financials, so being able to envision a startup’s future is a more important predictor of investment success. The reverse is true for private equity, where one can accurately assess the extensive and more stable financial performance of a company and thereby project its future with relatively more certainty.

This is a topic that I wrote about in greater detail earlier.

As a result of the more qualitative nature of venture capital investments, successful venture firms tend to have a culture that facilitates the surfacing of these accurate qualitative assessments. This, in turn, requires being able to see a business’ strengths and weaknesses, as well as the likely future paths that it may take, from different perspectives. This is difficult for an individual to do because of human attributes like confirmation bias, where one naturally looks for evidence to support a given perspective while discarding evidence that goes against it.

It’s easier to see different perspectives when you have multiple people around the table sharing their ideas with each other. This requires a conversational culture where people are comfortable sharing their views, respect the views of their teammates, and are willing to change their views when necessary to arrive at the most accurate qualitative assessment of the future. In other words, it requires seeing conversations as a means of arriving at the truth rather than an opportunity to show that you’re right.

For these reasons, successful venture firms tend to have a conversational culture.

A like-minded network

Venture capital is a private asset class. As a result, beyond evaluating companies well, knowing about and getting the right to invest in great startups are two important determinants of investment performance.

In addition, there’s a limit to how many great startups any single investor can know about and develop a sufficiently good relationship with for the entrepreneur to accept the investor’s money.

For an investor to know about and get the right to invest in a greater number of great startups, they need a network of people to refer them to these startups, and to vouch for them to the entrepreneurs of these startups. In other words, they need a network of like-minded entrepreneurs and investors with integrity, intelligence, personal energy, collective energy, and salesmanship.

In fact, many of our best investments, as well as many companies that we passed on which went on to be very successful, came from this network of like-minded entrepreneurs and investors. The figure is certainly larger than the number of our best investments which we discovered ourselves.

In addition to the professional upside of building and cultivating such a network, there’s the personal upside of spending time with people whose company you enjoy and who contribute to your growth.

And to be able to build and cultivate this network, you also need to deliver similar value to the entrepreneurs and investors who you want to be part of the network.

The benefits of illiquidity

Venture capital is a relatively illiquid asset class. In other words, since there isn’t a public market with significant supply and demand which produces real-time asset pricing, it isn’t easy to sell a venture capital investment after you’ve made it.

This illiquidity is correctly viewed as an additional risk which investors earn a risk premium for taking.

However, the same illiquidity also carries an advantage. Specifically, it is a natural opposing force to the human tendency to continually check asset prices and to trade in and out of assets when driven by greed and fear.

Frequent trading behavior is known as active management and studies show that the average active investor underperforms his more passive counterpart who simply buys and holds. This is to be expected because, each time that an active investor trades an asset, they lose the spread between the bid and ask prices of the asset while also incurring brokerage fees. And the average active investor’s returns don’t improve as a result of this frequent trading behavior.

This doesn’t mean that all active investors underperform. Some of them produce higher returns than passive investors. However, in the public markets, these are increasingly computer algorithms with tremendous data processing capabilities and low latency. The average active investor, who is increasingly a processing power-constrained and high latency human, produces lower returns than his passive counterpart.

In other words, the illiquidity of venture capital makes it harder to actively manage a venture capital portfolio. It forces you to buy and hold for much longer periods of time, and that’s a good thing.

The illiquidity of venture capital is also the reason why computer algorithms have yet to displace venture capitalists. Although that day will likely come, the success of a buy and hold strategy is less dependent on sheer processing power and low latency than the success of an active management strategy. Instead, the success of a buy and hold strategy depends on having creative and often contrarian insights. That’s where, for the time being, humans still have an edge.

Leading by Alex Ferguson and Mike Moritz

I recently read the book Leading by former Manchester United manager Alex Ferguson. The book also features an epilogue from Sequoia Capital chairman Mike Moritz. Many of the lessons which Alex shares for running a soccer team are equally valid for running a VC fund.

Specifically, Alex’s insights in areas like talent recognition and motivation, owner management, and media communications helped me consolidate and draw learnings from my experiences over the last few years. I imagine that most of these lessons are equally valid for creative roles other than football management and venture capital which also have very high returns to talent and involve working together with multiple stakeholders.

Featuring many tangible and candid examples, Leading is the best book I’ve read on how to operate in such a role. You can check it out here.

eBoys

I recently read eBoys, a book by Randall Stross about the founding Benchmark Capital team’s investments in the run-up to the 2000 internet bubble. These investments include eBay and Webvan.

The book is the result of the Benchmark team giving access to Randall to sit in on their internal meetings and interact with their portfolio companies. This decision was likely taken to market the newly founded fund and while it worked out in some respects, it also backfired in others. There are several instances in the book that the Benchmark partners would have likely preferred to leave out.

But setting that aside, the book provides valuable insights into the chaotic world of startups, the uncertainty which governs venture investments, and lessons from the run-up to the 2000 internet bubble.

If you want to read the book, you can buy it here.

Succeeding in VC and PE

Venture capital (VC) and private equity (PE) are two very different asset classes. Although both asset classes invest in private companies, PE invests in more mature companies with a lengthy performance record while VC invests in younger companies with a more limited, if any, operating history.

In PE, since the target companies have an established business model, lengthy operating history, and extensive financials, it’s possible to extrapolate from these to the company’s future. Although the actual outcome will be different than any individual’s projection, the range of projections is likely to differ by a small factor. The range of individual projections is unlikely to be more than an order of magnitude apart.

The target companies in VC have limited operating history and limited financials. That is if they have a business model at all. Sometimes they’re in search of a business model. As a result, the investment decision can rarely be based simply on extrapolating a prior performance record. It requires a qualitative assessment and insight rather than number crunching.

This doesn’t mean that valuation doesn’t matter for VC. It does. But the range of individual projections for a specific company are very likely to be an order of magnitude, if not more, apart. As a result, in VC you can afford to be off by a factor of 2 or 3 on the exact size of the outcome as long as you are correct in your assessment of the order of magnitude of the outcome. In PE, being off by a similar factor of 2 or 3 would be lethal.

As such, the profiles of the types of people who succeed in VC and PE are quite different. In PE, you make money by being quantitatively right. The qualitative direction is pretty clear. In VC, the accuracy of your qualitative assessment is the key driver of returns. You need to be in the right ball park quantitatively, but you make money by being right qualitatively.

Knowing whether you prefer and are good at making qualitative or quantitative assessments is key to knowing whether you’re likely to make a better VC or PE investor.