Ability, Sensibility, Repeatability, and Authenticity

I originally wrote this meditation on fund evaluation for my quarterly letter to investors, but thought I’d share it more broadly because people frequently ask me about my selection criteria.  Hope this helps:

Q3 2017 Commentary:

About a decade ago, a Bay Area billboard campaign for Diet Coke captured the ebullient can-do zeitgeist of the start-up world: “you moved to San Francisco with a crowd-funded website, dad-funded hatchback, and a no-funded bank account. You’re on!”

And indeed, a fundamental change in entrepreneurial finance underpinned this exuberance: while start-ups in the ‘90s typically needed to invest heavily in equipment, development, and customer acquisition just to get off the ground, advancements in virtual infrastructure, open source computing, and go-to market strategies enabled founders to launch companies in a lightweight way. Now able to scale in response to growth, rather than in advance of it, start-ups became radically more capital efficient. By some estimates, the amount of cash needed to get a company to first revenue had come down significantly, from the millions of dollars to the tens of thousands. “Fail fast, fail cheap” became a rallying cry as some joked that the cost to build a company approached the opportunity cost of unemployment.

A thousand flowers of optionality bloomed. Start-ups today are much more substantial businesses and continue to pioneer new industries while increasingly reshaping traditional ones. But this mass flourishing came with a cost: barriers to entry declined significantly and fast followers could now catch first movers quickly. Competitive intensity exploded as many “me too” companies abounded.

To be sure, the VC fund business was not immune to such dynamics. Outsourced service providers eased the administration of funds, fundraising friction decreased, and new platforms offered streamlined the fund formation process. An explosion in activity followed. For example, the so-called Micro VC segment saw the biggest growth in action. Pioneered by a handful of funds, the segment now encompasses over 450 such vehicles. In a typical week, our team will interact with a half dozen or more new teams. Unique ideas rarely stay that way for long; we joke that the time from “frontier technology” to mainstream is a couple of years today. Artificial Intelligence, for example, was a bleeding edge concept a few scant years ago but this fall alone we have seen almost a dozen AI-oriented funds cross our transom.

Unfortunately, the number of great deals is finite and the odds are stacked against new entrants. Yet intelligent and accomplished individuals continue to enter the field. Every aspiring VC seems to have a great story and one LP friend of our recently complained about being snowblind with opportunity. So how do we navigate through this whiteout? Some timeless touchstones guide our evaluation of VCs: outstanding ability, investing sensibility, repeatability, and authenticity.

The first criterion, outstanding ability, serves as table stakes in our discussions with potential new managers. Of all the common forms of investing, VC has historically experienced the widest spread between top managers and mediocre ones. VCs often serve as venture catalysts and their close engagement with companies requires that they have profound domain expertise to evaluate cutting edge companies and help them grow. In a world of competent practitioners, standouts need unfair advantage.

Our second standard, investing sensibility, is one that trips up many managers. The shiny newness of startups can be intoxicating and we see people frequently fall in love with companies, no matter what the price. As fervent believers in Buffet’s Equation, which observes that Opportunity = Value – Perception, we tend to be cynical about momentum plays. Silicon Valley’s spectacular self-promotion engine often allows valuation to outstrip medium-term promise in buzz-y companies. It is very common today to see start-ups attain valuations that assume perfect execution for the coming two years. But ultimately, some final buyer – whether an acquirer or a initial public offering investor – is most likely going to pay a price that has grounding in fundamentals, not hype.

Portfolio construction is another aspect of investing sensibility that can be overlooked. Many aspiring VCs have enjoyed entrepreneurial success. While some of their skills translate well to investing, especially company-building acumen and founder empathy, we have found that many fail to understand how to deploy capital in ways that generate attractive risk-adjusted returns at a portfolio level. Like a casino that rewards the senses with flashing lights and bells, Silicon Valley offers endorphin jolts that do not always correspond with investing success. Frequently, we will see fund managers crow about a win or two that might return some portion of a fund’s capital, but perhaps because of investment craft errors, these winners will fail to lift a fund high enough to overcome all the weak outcomes. Indeed, this is an area to which we devote considerable time mentoring VCs.

For us, the third criterion, repeatability, is also a critical factor. In a business with a poor signal-to-noise ratio, it can be extremely difficult to differentiate between the merely lucky and the truly skilled. Today, it seems that many fund managers are playing the odds, trying to hit it big with the next Facebook or Uber.   Indeed, a signature win can offer massive payoff to VCs, even if the fund-level returns are modest, and can create enough buzz to sustain new fundraising for a decade or more. We often joke that the venture industry uses lottery slogans with Ivy League veneer: optionality is a fancy word for ”you’ve got to be in it to win it.“ And, indeed, the business is rife with the managers who are “spraying and praying,” but those VCs that are able to deploy some unfair advantage, leverage ecosystems, benefit from experience, or hew to a consistent and thoughtful process can often make their own luck and enjoy more consistent results year-over-year and fund over fund.

Last, authenticity is an important vector of our evaluation. By this term, we don’t mean that we are looking simply for swell folks. Rather, we seek well-aligned robust nonconformists that have the courage of their convictions and demonstrate a consistency between their ideas and their actions. In a business that is plagued by considerable unhealthy egoism, we look for VCs that can demonstrate confident self-awareness. Those who have a keen sense for their own behavioral footprint, awareness of their limitations, and engaging demeanor are often those who can offer the best and most productive catalytic engagement with entrepreneurs as coaches and mentors. Additionally, these managers must be true Partners (with a capital P) to us and thoughtful stewards of the capital with which we entrust them.

Our task is not an easy one, but today’s advances in technology are truly breathtaking and we believe in what Whitman called, “the genius of the modern, child of the real and ideal.” Our framework described above helps us to organize our talents and energies against the endlessly challenging task of working with people or inventing the future. We could imagine no more humbling and exciting exercise.

Making the System Work For Everyone

When I was young, my dad used to tell me that there was a proverb in Greek that went something along the lines of: “there is a special shame in taking the last morsel of food.” The lesson was an admonition about not being piggish, or maybe showing restraint, or perhaps being gracious. Deep down, though, I always suspected that it was just a ploy to put the last slice of pizza in the fridge so that he could enjoy a late-night snack after I’d gone to bed.

When I came into the venture business 16 years ago, somebody told me something similar. Even though I forget who said it, I’ll ascribe it to Henry McCance, in my mind the font of all wisdom I picked up during that period (“when venture works well, capital is expensive and time is cheap.”) He said, “it’s important to leave something on the table for the next guy – that way the whole system can work for everyone.”

I used to think about that statement a lot. Individuals are incentivized to maximize, although optimization works better for the system. It’s kind of a Tragedy of the Commons problem, right?

I’d forgotten about both sayings in the intervening years, but recalled them again a couple of years ago when I started seeing overfunded rounds at vanity valuations and other cap table shenanigans. The apotheosis of some of the worrying trends seemed to come about 18 months ago. Back then, it seemed that companies were able to raise cheap and easy money at inflated valuations based on perfect execution of their coming two-year plans.

So here we are, almost two years later and some companies have executed and others haven’t – that’s the risk of venture – and a lot of companies that raised then are looking to come back for fresh cash. There’s definitely money still sloshing around and the trainwreck some of us were worrying about seems to be less imminent, to everyone’s relief. Although, I do expect some tensions as the era of easy markups may yield to a time in which “flat is the new up.”

Indeed, every dollar demands a return, especially those of the final investor, whether that might be someone in the public markets or an acquirer. If they stop getting value, they may stop buying what we’re selling; it’s the classic boom-bust dynamic of IPO windows. The anemic number of tech IPOs last year suggests that maybe the outside world has gotten wise to the fact that we’re leaving less for the next guy. The always-awesome Beezer Clarkson wrote a great outlook post at the outset of this year that talked about some of the ways in which the exit markets had evolved: “The market went from valuing growth to looking for sustainable business metrics, which not all VC-backed companies felt that they had to get the valuations they wanted.”

Which of course reminds me of Josh Kopelman’s seminal 2012 post about the JOBS Act that noted the post-SarbOx change in public and private market value creation in the past compared to that of recent years. The topic is a nuanced one, but Josh reminds us that among ten pre-SarbOx tech bellwethers, public investors were able to capture about 97% of the ultimate value creation.  Now that’s leaving something on the table for the next guy! Maybe too much; I’m not sure we need to return to those levels and the markets (both pubic and private) have changed in some meaningful ways, but there’s a happy medium somewhere between that and the dreaded “down IPO.

Over-Done Diligence

The best laugh I’ve ever had in a meeting came courtesy of my buddy Gordon Ritter. For those who don’t know Gordon, he’s got this awesome and disarming zany earnestness that would probably make him the perfect guy with whom to watch Russian Dash Cam videos: “Did you see those cows tumble out of the truck when it tipped over?!? AND WALK AWAY LIKE NOTHING HAPPENED?!?!?!”

But I digress . . . it was the spring of 2003 and I was meeting with Gordon and his partners as they were raising Emergence’s first fund.   As the meeting was wrapping up, Gordon slid a piece of paper across the conference table: “our reference list,” he said. I had been in the LP biz for a couple of years at that point and was feeling pretty clever. “Well, I like to do off-list references,” I quipped. Looking serious, Gordon started to rummage around in his bag. After a few moments, he said, “I’ve got an off-list list in here somewhere . . . “ I must have looked completely bewildered as I stammered, “but then the ‘off-list’ would be ‘on list’ and I’d have to go off-off-list . . .” At that point, Gordon couldn’t bear it anymore and broke into a wide grin that gave us all permission to crack up in hysterics at the absurdity of what I’d said . . .

I thought of this story the other day while hanging out with my buddy David Katzman. Over dinner, we mused that it’s possible to do too much due diligence. David reminded me that Fred Wilson wrote a great blog post on this subject a couple of years back. Fred is famous for his gut and has an amazing hit rate on his intuition. Kaztman and I observed that, in contrast, it seems that some outsource their thinking to others by doing endless research. Indeed, having sat in front of a thick diligence binder, I’ve often thought that there are a lot of heuristics that are the enemy of good decisions. Confirmation bias is probably the most insidious of these, but overgeneralization is also pretty sinister, too. Sometimes it can be easy to forget that data is not the plural of anecdote.

I’ve learned by watching some of the best investors around that having a well-formed thesis simplifies investing: if you don’t have a good sense for what you’re seeking, how will you ever find it without boiling the ocean? Pasteur famously said, “in fields of observation, chance favors the prepared mind.” And very practice of developing a thesis helps you figure out what questions to ask and where the data sources, especially the orthogonal ones, lie. Classically practiced diligence mainly helps one manage conventional risks as seen through the prism of other people’s biases.

In having a prepared mind, investors should strive to develop opinions, a scarce resource in a hurried, reactive business. Oftentimes, the more diligence you do under the guise of “getting smart,” the more your mosaic of facts will resemble everyone else’s. But I guess that’s ok when for people who think it’s better to fail conventionally than it is to succeed unconventionally.

Of course, some people are ok with being copycats and there are folks that distill diligence to one call: to their favorite bell cow. At Old Ivy, we had a few folks who simply tried to index our portfolio. The problem with that approach is that they often couldn’t access the things we were most excited about, not to mention the fact that we were pursuing a strategy specifically tailored to our needs. Specifically, we were exploiting some unfair advantages that we had, especially low liquidity needs and long, long, long time horizon. Confounding matters further, when people called me to find out what we at Princeton were doing, I only shared my second-best ideas. Should I feel guilty?

Probably not. Too many people are intoxicated by opiate-like embrace of the crowd.  Indeed, taking the time to develop an opinion and resist FOMO takes courage and an investigators eye while the easy path relies on unfocused and reactive probing that captures more noise than signal because of poorly tuned antennae.  Robust non-conformists with the courage of their convictions tread through the thickets of embarrassment and career risk that come from being wrong and alone in search of fortune and glory. We make the road by walking it. Which path will you take?



For the Moment Mellow . . .

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Since I too often bellyache on these pages, I thought I’d share something I wrote for a quarterly letter at the end of last year.  Ironically, the poem I reference is called Temporary Well Being. Comments and feedback encouraged, just don’t harsh my mellow, as the kiddos say . . .


Q4 Commentary:

A Kenneth Burke poem inscribed on a wall in New York’s Penn Station begins, “the pond is plenteous and the land is lush and having turned off the news, I am for the moment mellow . . .”

I’ve been thinking about this poem a lot recently, as Silicon Valley seems to be enjoying a sanguine moment. Although the tech world was consumed at the outset of the year by an unease that resulted from an investing pullback on the part of so-called Tourists – a cohort of large public market-focused investors who had become active in late stage private investing – the middle third of the year seems to have been marked buy a growing realization that the sky was not falling.   And by September, optimism engendered by a smattering of tech IPOs lifted spirits across the Valley.

Indeed, an uneasy truce between bulls and bears seems to have emerged as 2016 slouched to its conclusion. The headline of one of our favorite barometers, the Fenwick and West Venture Capital Survey, reported that, “valuation metrics were down modestly in the third quarter.” After all, the median round over round price increase among companies completing financings during the third quarter was 27%, down slightly from the second quarter’s 31%. While the Report noted that this was the lowest amount since Q4 of 2013, this rate of increase was right in line with the 10-year average calculated by the survey. Our conclusion, both from the data, as well as from our on the ground perspective, is that the entrepreneurial ecosystem seems relatively healthy; there are many great companies who are being rewarded by increased valuations for the progress they have made.

What has caused some consternation around the Bay Area, however, is the decline in mega-financings driven by the exit of the Tourists. The late-stage market, which had been defined by froth in recent years, has slowed. Financing used to be available to companies at levels that assumed perfect execution for the subsequent 18 to 24 months; there was a conceit that all of these companies would grow in to their valuations. Today, late stage investors are only paying for progress to date and acknowledging execution risk and uncertainty. As result, many venture capitalists to which we have spoken are suggesting to their companies that are fundraising to expect valuations that are 25 to 40% lower than they might have expected a mere 18 months ago.

This, of course, is good news for us. Buffet’s equation tells us that Opportunity equals Intrinsic Value minus Perception. As sentiment comes into line and folks acknowledge the reality of risk, prices should come down and our expected return should go up.

This new reality is being reflected in entrepreneur perceptions, as well. First Round Capital produces an annual survey of start-up founders and one of their typical questions is, “who has the power in fundraising negotiations?” In a 180° reversal of last years results, entrepreneurs this year’s survey said that power rests with investors by a two to one margin.

Of course, optimism is always empty without the prospect of healthy distributions. We are hopeful that the momentum of late 2016 will carry over into the new year and that both distributions and valuations will give us, the ultimate providers of the capital, reason for a continued excitement that we would have never thought possible at the outset of year.

As we look to 2017, the conclusion of that Kenneth Burke poem sums up our feelings nicely: “ . . . with my book in one hand and my drink in the other, what more could I want but fame, better health, and ten million dollars?”