I recently sat on a panel with Howard Hartenbaum, the founding investor of Skype, which yielded a 1,400x return in 36 months. Howard humbly noted that he was fortunate to have had such a deal so early in his VC career. In his words, "Skype was not the deal of a lifetime, it was the deal of three lifetimes!"
Venture capital is a hits driven business. Over time, it's likely that only 20% of the deals will generate 80% of the profits. (The 80/20 rule originated from Vilfredo Pareto's observation that 80% of his peas were produced by 20% of the pods. He also noted that 20% of the people owned 80% of the land in Italy).
Apply the 80/20 rule to the top 20% and the Pareto principle says that 4% of the deals will produce 64% of the returns. Apply it again and less than 1% of the deals will produce more than half the returns. You get the picture? It’s all about the homeruns.
Given the concentration of returns, LPs are lining up to invest in the "top funds" who have hit the biggest homeruns. Top venture funds are over-subscribed because it is believed that those who produced great returns in the past will continue to do so in the future.
As time passes, the gap between the winners and losers often gets wider. For example, about half of all returns in the VC industry have been generated in public markets due to post IPO (or acquisition) run-ups prior to distributions. If lock-ups and holding periods were longer, the gap would get even wider.
However, in the frenzy to "get in" to top funds, people seem to have doffed their thinking caps at the door. Even as the most sophisticated LPs are cutting back from many so called "top firms," new LPs to the asset class are not only taking their place but piling on.
Impact of consolidation
Over time, consolidation happens in just about every industry and venture capital has been no exception. A small number of firms have been growing to control a large percentage of the capital. Even firms with mediocre track records have been expanding in both scope and scale (because they are still considered to be "brand name" firms).
It's hard to turn down all that money flowing in, especially once people get used to a fancy lifestyle, nice offices, support staffs, and lofty salaries. Assets under management has become the proxy for success and VCs are becoming accustomed to making more money from management fees than carried interest.
With growth, the mentality of VC investment professionals has changed. When people get paid for activity (putting money to work) rather than results (which may take years to sort out) you will get more activity. Compounding the problem, there are pressures mounting to hit even bigger homeruns.
VCs are making bigger bets than ever (which are needed to move the needle on larger funds). Unfortunately, this is leading to value destruction of unprecedented proportions. Between 1990-2001, 63% of invested capital resulted in almost total loss (the median deal lost money). In contrast, between 1969-1985, partial or total losses occurred in only a third of the deals.
Predicting the future
A VC's job is to pick winners that emerge out of a confluence of technologies and markets. Some people seem to think that they can keep doing it even with bigger piles of money. Let's get real.
Obsessed with the future, all types of investors attempt to predict the future (usually by looking in the rear view mirror rather than out the window) - like the direction of interest rates, inflation, deficits, markets, etc. Unfortunately, predicting the future is hard to do.
Alan Greenspan once said "It's very rare that you can be as unqualifiedly bullish as you can now." That statement was published in the New York Times on January 7, 1973, right before the two worst years for economic growth and the stock markets since the Great Depression (yes, even back then he was considered to be one of the nation's top economic forecasters).
Ever the contrarian, as Fed Chairman, Alan Greenspan warned us about "irrational exuberance" before the last bubble crashed. Unfortunately, he said it in 1996. If you had listened to him, you would have missed out on the greatest bull market in history (when most of the venture returns were made).
Creating homeruns?
Alan Kay once said that "the best way to predict the future is to invent it" so perhaps the VC's job is not to pick the winners but to create them. Go visit any VC website and you will see a lot of chest thumping about how great they are at doing this.
Perhaps past successes have gotten into people's heads (see Leggo My Ego). VCs have started to think that they can not only see the next homerun coming, but actually create it (I'd bet that more than 75% of VCs think that they belong in the top quartile).
As a fan of baseball, I've observed that good coaches can help manufacture runs, but they can't do much to create the homeruns. If homeruns in baseball are the outcomes of duels between batters and pitchers, homeruns in the VC industry are the outcomes of battles between entrepreneurs and markets.
In the quest for homeruns, VCs invest tens of millions of dollars, "add value," and put together "world class" management teams to build companies. The funny thing is that it takes less capital to start companies these days. You don't need to pour money behind the homeruns because they don't need it. The best companies generate cash, even as they fuel growth.
Some of the biggest homeruns were not even venture backed - they didn't need the money. Even for those which were venture backed, many were already profitable at the time of funding and, with few exceptions, ALL of them required very little capital to become huge.
Let's get real. VCs don't create the homeruns. The great VCs do help their companies...but there is a fundamental difference in mindset. It's all about the entrepreneurs. The big VC firms may try to inspire confidence (or strike fear), but the best entrepreneurs do their own thing with or without the VCs.
Deductive tinkering
The hands-on, "get big fast" approach is the most common practice among VCs. The opposite approach is a hands-off approach where lots of bets are placed across companies. There's a method to the madness and some unconventional investors have done quite well letting natural selection take its course. People have called this "spray and pray" or the portfolio of options approach.
Unfortunately, a blind, random process (like evolution) can take a long time to play out. It is also risky particularly as bet sizes get bigger. To our knowledge, not a single significant company has ever been attributed to a spray and pray VC.
There are huge multiplier effects that stem from early decisions and we believe that it is critical to be hands-on. We believe there is a third approach. Venture capital should really be a process of deductive tinkering.
The best entrepreneurs are all classic tinkerers. They experience failures along the way (if you are not failing, you are not really experimenting), but they don't make foolish bets. They give themselves a chance to succeed (or get lucky) by making sure that they survive and stay in the game.
Thomas Edison failed in his first 100 attempts at making the light bulb...but he learned every time about what didn't work. We don't mind the failures. The key is to make the cost of experiments as low as possible. It's like flipping a coin where heads you win and tails you don't lose much. Flip enough times and the odds are that you'll come out ahead.
Some might argue that VCs invest big dollars AFTER the tinkering (to scale or "get big fast"). However, in our experience, the tinkering never stops. While we try to take out the greatest amount of risk with the least amount of dollars, companies take on new experiments at every level.
The idea that there is less risk at later stages is a fallacy. Competition to get into good later stage deals is far more intense (at later stages money is more of a commodity). Not only are valuations higher but a lot more capital is put at risk.
As our companies grow, we create new experiments within companies (it's like creating portfolios within portfolios). For example, several of our companies completed acquisitions or started new divisions over the past year. Our portfolio of experiments would grow even if we did no new deals as long as our companies grow in a capital efficient manner (where we reinvest retained earnings rather than other people's money).
Risk and uncertainty
Conventional wisdom says that in order to shoot for higher returns you have to take on greater levels of risk. We choose to follow a different path.
We look to invest in highly uncertain situations. We call such deals "experiments with unknown upside potential," where the range of possible outcomes is very large (on the upside) but require little capital. This is better than gambling or lotto which have defined, bounded upside. We'd rather take unknown/unbounded upside and known/limited downside.
One of the ways we like to limit downside risk is to invest in bootstrapped companies. In our most recent fund, more than half of our Series A investments have been made in companies that have been in business for several years. Such companies seem to learn more than companies that burn through millions of dollars. People with less money learn to use their brains more.
In other cases, we might even invest in companies that are already profitable but might need a little extra capital (and some assistance) to accelerate growth. Many VCs as well as "growth equity funds" who target bootstrapped, profitable companies have minimum investment sizes of $20 million or more. We look to invest less than a quarter of that.
A third type of investment is starting companies from scratch...but following a deductive tinkering process, rather than a conventional one (see Venture Lotto). The beautiful thing about our business is that we don't need to predict the future. We just keep our eyes open and learn along the way.
Learning requires an active, hands-on approach (so there is a cost) but it leads to value, often realized in totally unexpected ways. Some of our most successful investments are directly linked to a past a disappointment or failure.
We don't feel the need to take on big risks. One of the great advantages of venture capital is that even multiple failures can't "blow-up" a fund (see articles on LTCM for how billions of dollars can be lost in a matter of days. Hedge fund and other types of blow-ups are discussed at length by Nassim Taleb in "Fooled by Randomness" and the "Black Swan"). There is a huge difference between high risk and high uncertainty. We prefer the latter.
The conventional VC strategy of investing tens of millions of dollars is a risky proposition. There are thousands of venture backed companies that burn through millions of dollars only to get to a point where they seek even more funding to grow. We have some (rather painful) personal experience with this. Some of our companies have gone through Series A, B, C, D...and then after running through most of the alphabet started over with Series 1 or A1.
After making more than our fair share of mistakes, we've realized that such impatient consumption of capital creates fundamentally weak companies. Compared to our bootstrapped companies, they seem to have a much lower chance of becoming a homerun, unless another bubble bails them out (depending on the greater fool is an awfully risky way to try to make money).
VCs cannot manufacture the homeruns by pouring tens or even hundreds of millions of dollars behind companies. It's like pushing on a rope. Such a strategy requires not only a lot of capital but a lot of confidence, ignorance or arrogance. Perhaps VCs should remember the words of the great hall of famer Satchel Paige: "It's not what you don't know that hurts you, it's what you know that just ain't so."
Expecting the unexpected
New technologies can lead to waves of creative destruction. Even in low tech industries, companies come and go. The vast majority of Fortune 500 companies drop off the list much faster than it took to get there - creative destruction is everywhere.
Small innocuous events can set off avalanches of changes which are inherently impossible to predict. Such unexpected changes are extremely dangerous for the giants (who have everything to lose and not a lot to gain). At the same time, they can be hugely advantageous for the hungry new entrants who have everything to gain and little to lose. The beauty of venture capital is that we can bet small but win BIG!
Experimentation and failures go hand in hand - so it's critical to limit the dollars. Lots of money is not required to get value out of experiments - it takes a little patience, an open and prepared mind (willing to observe, learn and adapt), and the right attitude toward risk and return.
Venture capital should not be about putting money to work. Over the years, we've learned that if we focus on the fundamentals and keep doing intelligent things, we can make money even if a company is sold for less than $50mm (the typical value of M&A exits in the VC industry). Rather than trying to predict or create the homeruns, the focus should be on the productivity of capital.
If we build good companies, we've also discovered that some of our companies will just keep growing and growing. We just have no clue which ones will take off (and keep going) and which ones won't at the time of investment. However, we have faith that some of our companies will become the dominant new market leaders (we have several promising ones so far). Creative destruction favors the new entrants.
The key to great returns
One of the legends of the VC industry recently told me that to be a great VC "you must have the courage to walk away." Maybe it takes courage because mainstream VC investments are becoming so big that they seem too big to fail?
We have a different view. If you invest very small amounts and the experiments fail, it doesn't take much courage to walk away. Our "losers" seem to do a fine job of dying without much help from us - they don't need to be killed.
The key to great venture returns is not the courage to walk away but deep conviction and passion for the big winners (see our Raising Sheep article on the issue of conviction vs. convention).
To paraphrase another great VC...the key is to have a little teflon coating so that you don't get jaded...you have to have the ability to fall in love - with technologies, entrepreneurs and companies - even after you've had your heart broken. Great VCs are just as passionate as the entrepreneurs. It's personal, not just business.
However, perhaps paradoxically, it's also critical to be rational. The homeruns are rare - really rare. If you think that everything can be a homerun, you probably won't even recognize one when it stares at you in the face.
Over the course of decades (if we are lucky enough to be around that long), a very small number of our deals will yield more profits than all of our other deals combined. It's just the way the math works. We can only lose 1x, so if we have a 100x or a 1,400x along with a bunch of 3-5x winners, the overall numbers will be skewed toward the few big homeruns.
So in between the homeruns, the key will be to keep losses to a minimum, learning to a maximum, and generate decent enough returns to stay in the game. Such an approach might not sound terribly sexy or exciting, but we believe that the key to achieving great results is to stick to a rational strategy (rather than gambling money away).
The great investors and businessmen we know are all pragmatic practitioners. They first think about (and protect) the downside, before going for the upside. Following such a strategy takes a lot more faith and courage than you might think. It forces clear headed thinking and hard, disciplined decisions rather than sloppy, wishful thinking and shoot-from-the-hip betting.
Ultimately, it's not about how much we invest but what we own of great companies. We feel - in our bones - that only a few companies will really matter in our lifetimes (and they will NOT require a lot of capital). So, like every other VC we're swinging for the fences too...but we're not going to leave smoking craters in the field if we don't clear the fences.
