Lessons from a professional gambler

Every year, we host a meeting which brings together entrepreneurs, investors, and other members of the extended "Altos family." One of our speakers this year was Jeffrey Ma, whose adventures as a professional blackjack player were chronicled in "Bringing Down the House." Here is an excerpt from the book (Jeff's character is Kevin Lewis, the protagonist).

"He found himself escorted to a private booth in a newly opened club at the Hard Rock Hotel. Surrounded by strippers and starlets from L.A., Teri, on his arm,... Kevin watched the flickering lights and wondered if life could possibly get any better. He had seventy thousand dollars in a money belt around his waist and another quarter million back in his room. Card counting was the key that had unlocked the casino's coffers, and there was no reason to think the party ever had to end."

So what does this have to do with entrepreneurship and venture capital? Surprisingly, after telling some funny stories, Jeff drew interesting parallels between his former profession and our business.

First, the thing Jeff missed most about his days as a gambler was not the high stakes betting or the hobnobbing with celebrities. It was the fun and the camaraderie he felt being part of a great team. Every team member handled large amounts of cash so trust was paramount. Eventually, he found it again at Protrade, a start-up he co-founded. As we've stated before, there is nothing more important in our business than people. The commitment and passion of entrepreneurs is infectious and the best ones are able to form teams with deep common bonds.

Second, maintaining faith as well as discipline and patience is critical. In blackjack, you can do all the right things and still lose bets. Jeff eloquently described some intense moments when he could have given up, but instead kept going. In professional blackjack, perhaps it's easier to maintain faith because it’s about math. In our business, there are no card counts. However, we have faith because there are levers under our control. We avoid doing foolish things like playing venture lotto, and increase the odds by patiently following our strategy, making good decisions, one at a time. As the saying goes, "luck is what happens when preparation meets opportunity."

Third, it is critical to maintain discipline as you grow. After delivering great financial results (47% IRRs), everyone wanted to invest more money in Jeff's blackjack fund. Greed took over and fund sizes grew fast. They had to make bigger bets and target larger casinos, increasing the chances of getting caught. (Jeff eventually broke off and formed a smaller team).

In venture capital, success inevitably leads to opportunities to raise larger funds. Only a handful of firms turn away money (there is a difference between a fund which may be "oversubscribed" after trying to create a feeding frenzy and funds like Kleiner Perkins and Sequoia who effectively turn away billions of dollars). Partners at certain firms also commit significant personal capital. In contrast, the vast majority of fund managers personally commit only the minimum (1% of capital) while taking full management fees and share of profits, with no downside risk.

The real issue with larger funds is that interests start to diverge between VCs and entrepreneurs. VCs have incentives to swing for the fences while entrepreneurs prefer lower-risk paths. Entrepreneurs can't count on a portfolio. Also, entrepreneurs don't collect management fees, which are becoming a critical component of investor compensation. Large fees create an "asset manager" mentality - the incentives are to "put the money to work." Without alignment of interests, it's hard to develop the trust and bonds needed to build great companies.

To align interests, VCs should raise smaller funds, invest more personal money, and focus on building solid businesses rather than exits. This will lead to less failures and, paradoxically, lead to larger homeruns because companies will be built on customer funding rather than on investor funding. Too much money stifles creativity, drains the hunger, and makes it more difficult to create company DNA which is tested against market realities. The brute force method of company creation rarely works. It's like pushing on a rope.

Even highly risky ventures can be capital efficient. Companies which never raised venture funding include Autodesk, EMC, RIM, Qualcomm, SAP and SAS (for a longer list see the post on venture lotto). Companies which were already profitable and well on their way to success by the time they raised venture funding include Apple, Cisco, Microsoft, Oracle, Intuit and eBay.

In the case of Apple (I have a copy of their original business plan), the initial round, completed in January 1978 when they were already profitable, included Venrock $288,000, Sequoia $150,000, and Arthur Rock $57,600. The initial round of Cisco was $2.4 million split between two VCs. They were in business for two years and already profitable by the time they raised Series A. The next round was IPO.

Companies which burn through lots of capital usually end up as acquisition targets or fail in spectacular fashion. Some may end up being nice "exits" but they don't become enduring, great companies.

What was meant to be a fun, lunch-time distraction from a full day of company presentations and investor meetings turned out to be quite relevant. Thanks Jeff, for keeping it fun and real.