robgo.org

I’ve been reading the book “The Black Swan” recently on the recommendation of my two partners.  I had heard about the book for years, but it never made it off my “to-read” list until now.

One of the concepts that the book discusses is the way we think of risk differently when we are generating profits vs. when we are minimizing losses.  The simple illustration goes something like this:

If someone gave you the offer of $100, no strings attached, vs. flipping a coin for the chance of winning $200, what would you choose?  Although both options are mathematically equivalent, most folks would choose the $100.

On the flip side, if things were reversed, and you could either lose $100 for sure, or have a 50% chance of losing $200 or nothing, what would you choose?  Most people in this situation tend to prefer the possibility of losing nothing, even though there is the 50% chance of a larger loss.  

This illustrates a simple point that we tend to be irrationally risk tolerant in protecting capital.  Social scientists call this loss aversion.

This has major implications for the venture business in the realm of follow-on investment decisions.  It’s a part of the business that doesn’t get much attention, but consider this:  I think it’s safe to say that well over 50% of a typical venture firm’s capital actually comes in after the initial investment round of financing for a company.  So even if a fund is supposed to be “early stage” focused, the reality is that the bulk of their capital is going into the follow-on investments in the B, C, D and later rounds. 

I didn’t realize this before I went into VC, but most VC firms are lifecycle investors, meaning that they have large reserves and expect to participate in most of the follow on rounds for companies that are doing reasonably well.  One would think that the follow-on investing decision for VC’s would be an easy one.  After all, no one has more information on a company than the existing investors and board directors.  Therefore, they should be very well equipped in figuring out which companies deserve follow-on capital, and which ones don’t.  Even though the follow-on capital is usually at a higher cost base than the earlier investments, this should be concentrated in the “best” companies, and should perform very well from a risk adjusted basis (even before considering the protection from being higher up in the preference stack).

Case closed right? Wrong.  There are a lot of reasons why follow-on financings might happen when they shouldn’t, causing VC’s  to “pour in good money after bad”.   

• Loss Aversion.  As discussed above, the uber-reason this happens is that one is irrationally risk tolerant when trying to preserve capital.  Or put another way, once you have a vested interest (time or money) into a company, you are willing to take irrational risks to protect your investment.   

• Delayed Gratification.  No investor wants to see a “zero” on their track record, and no investor wants to report “zeros” to LP’s.  This is true even though a small -100% return today might be much much better than a big -80% return in 5 years.  The pressure of needing to raise a future fund, looking good in front of your partners, trying to get promoted, trying to look like a clever guy in the twitterverse, etc leads to unnecessary risk-taking in follow-on financing decisions.  Even though almost every firm says they evaluate follow-on rounds like “new deals”,  I think this is actually far from reality.

• The Signaling Death Spiral.  Let’s take the hypothetical case of a company raising a series B that is doing ok, but not great.  The existing investors will often say they will support the company but have an outside lead price the round.  The new investor will ask the existing investors if they are “in” for their pro rata as a signal that it’s worth investing.  If an outside lead is willing to price and lead a round, it’s very very hard for the existing investor to say “you know what, I don’t believe in this.  I’m going to pass on this investment and risk that the whole deal blows up” (note that this is different than the follow-on dynamics of VC led seeds, where the investor will have a much smaller % of capital at risk and knows that they are buying 5 options to make 1 true investment.)  So in this scenario, a follow-on round gets done, and both parties are heavily influenced by the fact that the other is investing.  Puzzling no?

• Confirmation Bias.  This is the tendency for people to favor information that confirms their preconceptions regardless of whether that information is true or complete.  When layered in with Loss Aversion, it creates a deadly combination.  Because an investor is averse to losses, he/she is biased against any data that suggests that the initial investment decision was a mistake and will gravitate towards information that supports a follow-on investment.  

• The Bridge to Nowhere.  Even if a company is really struggling, the following logic is very appealing: wouldn’t you be willing to spend $2M to save the last $8M?  Because investors usually buy preferred stock, they get paid first and so they only need the company to sell for the value of the preferred stock to get their money back.  As a result, you often see struggling companies raise inside rounds under this logic (often crushing the employee’s equity in the process).  But many times, this round of “bridge” financing ends up being a bridge to nowhere.  

So, follow-on investing ends up being a much more complicated endeavor than it would first appear.  Clearly, there are some firms out there that have a great deal of discipline about follow-on financing and have been very successful.  But I think that this is a very very easy way to falter as an investor because it’s so natural to fall prey to these pitfalls.  As some super-angel funds increase in size, it will be interesting to see how they deal with these hurdles as well.  It’s easy to say that one will “pile in on their winners”, but the ability to do so will cut both ways. 

Hi, I’m a tech VC on Twitter. I’m @xyzvc

My icon is cool.  It’s a painting/cartoon/wacky photo.  Shows that I’m hip and approachable.  But when I meet with you, I’ll still crush your dreams. 

I tweet about technology, but occassionaly post personal stuff.  Important to show I have a sensitive side and care about more than just making tons of dough. 

I use # tags, sometimes as a funny form of emphasis.  Kind of like a wink and a smile ;) #donttakethisposttooseriously

I love Twitter because I can broadcast my blog posts.  Otherwise, no one would read them!  I blog at xyzvc.com!

I tweet blog posts with advice on fundraising, customer acquisition, and company building.  Usually, someone really smart has said it before and said it better.  But I haven’t been in Hacker News for a while, so I figured there is no harm reinventing the wheel. 

Retweeting is fun.  It’s like a virtual high-five.  I retweet the posts of my partners, coinvestors, and entrepreneurs I’ve backed.  Oh, I also retweet posts from guys whose butts I’m currently kissing so that they will like me.  I really hope @fredwilson retweets this… I’d get so many new followers!

My portfolio companies are the best.  I will share so much of their good news with you it will make you want to unfollow me (unless you are a co-investor, in which case you will probably RT and add a #)

If a portfolio company is doing bad, no Twitter love.  It’s like going to Disneyworld and trying to find Hercules or Mulan.  It’s like they never existed.

I also tweet about the cool places I’ve been (via Foursquare and Gowalla), things I buy (via Swipely and Blippy), and the cool places I’m going to go (via Plancast).   

Wow, that’s a lot of tweeting! That’s why I also tweet about how busy I’ve been and how little I’ve slept. It’s a tough life. 

Full disclosure, I’ve been a tech VC and I’ve done most of these things. 

When I joined the venture business, I was told that the job is a lot harder than it looks.  You need to find great companies to invest in, work hard to make them successful, and work even harder to try to make the most of the ones that aren’t going so great.

But what I found to be much harder than I expected was the process of choosing companies, and having deep conviction about those choices in the midst of vast uncertainty.  It’s also difficult to exhibit clear judgement when you learn more about a company and uncover things you didn’t expect to find.  It’s an intangible quality that I’m going to call investor mojo.  As one of my colleagues Santo wrote in an old blog post:

“If I did not foolishly think I knew everything and would be right most of the time, I could not be in this business. It is hard to be often wrong - historically only 1 or 2 in 10 companies provide meaningful returns - and live with it.”

I didn’t have an appreciation for this because I used to hear about new companies all the time, and always had an opinion.  In fact, I never had a hard time saying “that company sounds really interesting” or “that investment sound really dumb”.  If you look at the comments section after any new investment announcement on Techcrunch, you see a lot of similar comments from folks from all walks to life.

But there is a world of difference between making a passing judgement and really committing your time and money to a company.  Maybe it’s just me, but it’s a completely different exercise when you decide that you are going to love a deal and pound on the table to make the investment happen.

By “pounding the table” I don’t mean that every investment decision is contentious.  But the truth in early stage investing is that almost all companies have a few fatal flaws.  Maybe it’s an inexperienced founder, a product with no traction, or something else entirely.  For almost any new investment announcement, there is bound to be a sizeable population of folks who say “wow, that was one dumb deal.” I’m as guilty as anyone.

But being a great VC is about proving all the doubters wrong.  Actually, that’s true about being an investor in every asset class.  Outsized returns comes from doing things differently from the herd.  As Warren buffet famously said:

“We simply attempt to be fearful when others are greedy and greedy when others are fearful”.

What he didn’t say is that doing this also exposes you to the risk of looking stupid.  Unless of course, you are Warren Buffet and you just bought a railroad.

VC’s pass on new investment opportunities more than 99% of the time.  My guess is that the clear #1 reason why we pass is because of the team.  This could mean a bunch of different things (eg. no confidence the team can execute well, personality clash, etc).  But I don’t think there will be much dispute that this is the main driver behind a “no” decision.

The #2 reason is NOT as obvious.  “Bad Product” or “Unattractive Market” are definitely up there.  But I will contend that the second most popular reason VC’s pass is because the company “can’t get big enough”.

This is something I hear all the time among VC’s and I know it must drive entrepreneurs crazy, because no one thinks that they are giving their time and energy into an idea that is not “big enough”.

What does big enough mean?

There has been a lot written about this so I won’t rehash the math.  But the basic idea is that startups have a high mortality rate.  And so the relatively small % of winners need to be significant enough to drive an impactful return for the fund.

Although a lot of posts speculate that VC’s block good outcomes because of this, I doubt that it’s as prevalent as it seems.  What is prevalent is that VC’s think very hard about whether the potential of the business is big enough relative to the time and capital investment required.  We also think very hard about whether the founder is interested in shooting for a big outcome.  If not, it’s a tough fit for a venture capital investment.

Why many entrepreneurs should accept this reality (and why some investors should take advantage of it)

The reality is that most businesses probably can’t get to the kind of scale that VC’s require.  Moreover, it’s damaging to the business to do unnatural things to try to get to that scale.  You may grow your team too quickly, forgo revenue for reach, hire expensive executives, etc.

These aren’t bad things, but they aren’t right for all businesses.  I think there are a lot of very rational businesses out there that can probably get to profitability and modest revenue and create a lot of personal wealth for those involved.  Building these businesses can look quite different from building a venture funded company, and the funding strategy ought to be different as well.  Funding may not come from the highest profile VC’s (at any round in the company’s life) but from wealthy individuals with deep domain knowledge in your sector, professional investors with a different set of economics and strategy, or good old fashioned cash flow.

I would say that I think there is a dearth of investors for this sort of company, and I think there is probably an opportunity in this sector of the market. I also don’t think such an investor is necessarily dooming themselves to mediocre returns in small companies.  If they invest in the right markets, I think 1 or 2 out of 10 companies might surprise them and actually yield traditional venture returns.

Why entrepreneurs shouldn’t lose hope in VC’s

Despite the reality that most businesses can’t get to venture scale, an entrepreneur may be absolutely convinced that their company is an exception.  If this is the case, don’t lose faith in VC’s!  If you think about a lot of very successful companies, many of them probably looked “too small for venture” in their very early days:

“Pez dispensers and collectables online?  Tiny market!”

“Free calls online?  How will Skype ever make money?  Too small!”

“A coffee shop with a goofy name and a mermaid logo?  Too competitive, can’t scale.”

The goal then, is to find an investor that shares your vision for how you can get big (and is willing to endure criticism from others who don’t see the same opportunity).  Sometimes, these investors just have a conviction about where markets will go.  Or they just have a love for what you do and unique ideas about how to win through better execution.  This takes some time to figure out, but it is getting easier as VC’s are becoming more transparent about their investments, themes, and thoughts on market evolution.

I also think that these are the VC’s who tend to be the leaders in the industry rather than the followers.  The first investors in category creating companies tend to look like idiots for a while before the company goes from “not big enough” to the clear leader in an emerging new sector.  Then the lemmings follow.