What’s Hard and What’s Not as a VC.

I often ask entrepreneurs during pitches “What’s hard to make this a successful company?” I am particular about this one.  I am not asking “what’s difficult.” Difficult is fundraising, hiring great people, finding customers, making customers pay on time, getting renewals, opening a new office, etc.

“What’s Hard” is something that hopefully the entrepreneurs are better at than anyone else in their peer group, and something essential to make their startup successful. Hopefully, the entrepreneurs have some reasons-to-believe — anecdotal or otherwise — that they are well suited to address “what’s hard.”

Last Monday, however, after a phenomenal meeting with a great entrepreneur, that question was turned around on me:

“So what’s hard as a VC? What do you think is hard about your specific model?”

It’s so easy to say yes. Spending money is always easy, getting it back is the hard part. I believe great VCs have to have (1) a deep sense of intellectual honesty, they have to be (2) sophisticated story-tellers, and they have to (3) constantly evolve their skill sets.

Intellectual Honesty

.. towards your own abilities: It is so easy to get sucked into a deal: You like the technology, you like the product, you like the founder, you like the existing investors, it’s a hot deal with lots of interest from other VCs, it’s a hot sector, … the list can go on. But what are you and your firm good at? If you spend the $$ on this specific deal, how will you have a transformational impact, more than the other investors? You will spend considerable time helping this company succeed over the next six to eleven years. But could you have helped another company instead? Could you have had a greater impact there? Would that have accelerated your performance? Venture Capital is a very long game. In many years from now, your success stories will drive better deal flow and help you raise your next fund. But not if you had no impact.

… towards the performance of your companies: You are enchanted with your portfolio companies, especially the ones you sourced (versus some of your partners). So where do you spend time — and how much time — because it’s the right thing to do? Where do you spend time — and how much time — because of the transformational effect it would have on the company’s outcome (and ultimately your own outcome)? Where do you deploy more capital — and how much capital — because of the return that capital will get you?

Fred Wilson writes about the second quartile of portfolio companies:

But the second quartile will try your patience and your conviction. These investments often take longer to realize. And you will have to take endless calls from friends in the VC passing on the investment for all sorts of good reasons, but always come down to “it’s just not exciting enough to us.” You will have to talk your management team off the ledge countless times. You will work harder to recruit new talent. You will put more money into them than you want to. You will struggle to get the business profitable. You will wonder if you have lost your objectivity.

And then one day, you will get an offer from a buyer to acquire the company for hundreds of millions of dollars. And then all of that effort and conviction will have been worth it.

Fred Wilson, The Second Quartile, December 2017

… towards your partners and LPs: Are you documenting facts, figures, performance, due-diligence interviews mostly verbatim, or rather “interpretive,” as in “I think I heard them say <xyz>”? Are you trying to get a deal closed and are omitting some new findings that would be hard to consolidate with previous assumptions? Are you telling LPs why certain investments did not perform as you thought, what you learned from it, and what the proprietary insights are you gained? No LP wants to pay for your failures, but they’d rather you learn from them and gain an information edge over other investors than not. Sooner or later, your mistakes will come to light. In venture capital, this might take an extraordinarily long time, but it will happen eventually. If you are not forthcoming, at best it will either destroy the partnerships or make it more difficult for raising future funds. At worst, you will continue making the same mistakes and end your career.

Sophisticated Story-Telling

The dichotomy of leadership in venture capital — because there always is one — stems from the uncertainty in venture capital deals. I wish there were a formula to identify great investments. So far, only Correlation Ventures might have found the right data points to track to reliably identify investments with high potential. But even they are partly driven by the conviction of lead investors. Venture capital is a conviction game: you have limited information and facts, and you and your partners need to find the conviction that this deal is the right one, according to your portfolio modeling. Finding that conviction requires story-telling to fill in the blanks, and then test the story against your beliefs and your judgment of risks (the probability of irreversible and catastrophic events).

Venture capital investments are likely to fail. If you only look at past performance, the n+1 investment is likely to fail. So what is the story that would convince you and your partners that this time it’s different? What is the story that passes the probability and returns hurdle of your portfolio construction? If you cannot exit your partners, who are deeply involved in similar sectors, if not the same sector, how can you excite your Limited Partners at your next annual meeting? Chance are, you are trying to raise your next fund about two to three years after your last one. By that time, few investments will have provided the 10x liquidity your portfolio needs, so most of your LPs decision to back your next fund will be founded in your story telling (and your intellectual honesty).

Evolve Skill Sets

Given the uncertainty of venture capital, evolving your skill sets is a bit harder than in other professions. How will acquisition appetite change in five to seven years, when your portfolio companies might exit? How should you look at the financial performance of your portfolio companies? How do new trends influence trajectories or disrupt startups? Are these new trends having a fundamental impact on the mechanics of startups and venture capital? How will new startups in SalesTech and MarTech change the way your own portfolio companies are selling? How do you evaluate cryptocurrencies or token-based startups? How do ICOs or STOs fit into your portfolio (if at all)? How will Limited Partners look at your portfolio in two to three years, when you want to raise your next fund? Do you need to learn how to invest in new sectors? How do you learn that skill-set, if not through failures?

I am fortunate enough that my current firm allows me to peak into a wide range of what we believe are the very best early-stage venture capital investors. And by meeting with other funds and emerging fund managers, I see the additional trends and early signs of industry changes. But because venture capital is feeding on gaining a proprietary information edge, “asymmetric information,” I cannot wait until a trend or best-practice is established. We have to charge ahead and lean into our beliefs and create our own destiny.

Thoughts? Opinions? Comments? Corrections?