To the casual observer, investing is nothing like the exciting game of basketball. Instead of evaluating a player’s jump shot or ability to slip a screen, VCs are looking at financial statements or pitch decks. Upon closer inspection though, I’ve realized that running an NBA basketball team and venture capital investing are remarkably similar. They are both highly competitive games of skill and chance. The games involve the allocation of scarce resources and have power law dynamics for returns.
I’ve been a basketball fan almost from birth, as I was born in Boston the same year Larry Bird and the Celtics won the NBA title. My interest in the NBA has expanded over the last couple of years, and it has to do with NBA “stars” most people probably have never heard of — men like Sam Hinkie, Daryl Morey, Danny Ainge and others in that vein. They are NBA general managers, and they make the important personnel and capital allocation decisions for constructing their respective teams.
I’ve become fascinated by the game behind the game of the NBA. Plenty has been written about how data and analytics have transformed basketball over the last several years, leading to the smaller lineups, faster pace of play and the supremacy of the three-point shot. But I think there are also some very important lessons that all investors, but especially venture capitalists, can glean from the NBA GM’s allocation of scarce resources, and the decision science behind those allocation decisions.
One of my favorite GMs, Sam Hinkie, who formerly managed the 76ers from 2013–2016, is a great example here. For those who are unfamiliar with his career, he was forced to resign before the 2016–2017 season. The reasons for his dismissal will be clear in the essay, and I think it will also be clear that it was a big mistake.
1) Know the rules of your game
The ostensible goal of the General Manager is to form a team that wins championships. There’s a simple strategy to do that, which Sam Hinkie succinctly sums up in this tweet:
Basically, if your team has one of the eight guys that Hinkie mentions, and barring playing against each other in the same conference, you are making the NBA finals. Most of those players also played their entire career, at least the part with the highest performance output, on one team. The exceptions being 1) Shaquille O’Neal, where the Orlando Magic blew it, and then later, Kobe forced the Lakers to trade him and 2) LeBron and “the decision”. Put differently, almost all those players, played their best years with the same team that drafted them.
It would also imply that if you are the GM of an NBA team, your job is pretty simple: draft an anomalously great player. The problem is, the draft is a game of chance. For every Tim Duncan, Magic Johnson, Lebron James drafted with the 1st overall pick, you also might get Anthony Bennett, Greg Oden, Darko Milicic, and Kwame Brown. Like with any game that involves probability, sometimes you just get unlucky. The image to the left shows the dispersion of outcomes for various draft picks (taken from Ben Falk’s blog.) The higher the draft pick, as well as the more draft picks one has, the higher the probability of drafting a generational talent that drives power-law returns. But, as our compliance officer likes to note: “Returns are not guaranteed.”
Analogy to venture capital:
Venture capital returns also follow power laws. Between 1985 and 2014, Horsley Bridge, a leading fund of funds, found that 6% of deals generated 10x+ returns and made up 60% of returns. The dispersion and magnitude of outcomes are heavily skewed to the outliers. This is similar to drafting basketball players. Replace the eight basketball player names that Hinkie tweeted with these: Google, Airbnb, Uber, Facebook, Whatsapp, Instagram, LinkedIn, Zillow.
Venture capitalists should be looking for investments that exploit this convexity. Though, it goes without saying that investing in earlier stage companies increase the convexity of the bet, investing in every early stage company you can won’t improve the portfolio’s outcomes. As a category, Venture Capital underperforms the alternative of just investing it in the stock market.
I chose those eight names because I invest exclusively in consumer Internet businesses. They exhibit some common traits that I don’t want to commoditize in this essay, but one could do the same for any stage, strategy or sector, from public markets to consumer hardware startups. For example, if you are a SaaS investor, find the common traits of the following software businesses: Salesforce, Workday, ServiceNow, Box, NetSuite, Veeva, Atlassian, Twilio. Have a hypothesis about where there are outsized returns, test that hypothesis against the historical examples to see if you are right, make a few investments, learn and adjust accordingly. The convexity, and therefore the risk appetite, might be different but the method of creating a process is similar.
Once you’ve identified those common traits, invest in businesses that exhibit those traits as often and as early as possible. Do it every time. Sometimes you’ll lose your principle, but that’s the great thing about high convexity bets, you can only lose your ante while the winnings can be many multiples greater.
2) Maximize access to scarce resources
Sam Hinkie, combined two truths: 1) you have to draft a generational talent to achieve sustaining superlative outcomes and 2) the more draft capital and the higher your draft picks are, the better your probability of drafting a generational talent. He then triangulated a strategy of maximizing draft capital by sacrificing short term gain. This strategy was widely known as “The Process.” In the first 26 months of Hinkie’s tenure, the 76ers acquired 26(!) draft picks or options to swap draft pick positions. For the non-NBA fan, that is truly remarkable.
Analogy to venture capital:
This is venture capital’s unfair advantage over the NBA. As a GM of a basketball team, you have three main scarce resources to drive surplus value: 1) draft picks (every team gets 2 picks each year and they are tradeable); 2) roster spots (capped at 15); 3) salary cap (there are complicated exceptions but basically salaries can’t exceed ~$100m and it changes based on the NBA’s revenue that year).
This is probably hard for new / emerging fund managers to read, but the scarce resource in venture capital is actually not capital. It is the time of the fund manager. There are SO many implications if you believe this to be true. Investors should make as many investments as possible that fit within the strike zone while maximizing ownership and win rate. Try to remove any and all constraints that make this a challenge. I’ll take a stab at pointing out a few tactics that I’ve seen some investors employ:
- Convince their portfolio companies to allow investments in competitive companies, so they can make multiple bets in a sector that they like (i.e. crypto or AI)
- Avoid taking board seats so they can spend more time investing, and instead, hire professional board members in their stead
- Hire an army of junior investors as a filter so that the senior partners can maximize their time spent with the best opportunities that come out at the end of the filter
- Unbundle the services that a single partner would traditionally offer and provide a suite of services like recruiting, customer introductions, marketing, PR, etc.
- Allow junior investors to make investments, federating the time commitment of earlier, riskier investments to the lowest cost provider.
Mixing and matching a combination of a few levers is also a tried and true option. I’m sure there are other methods to “create” time but understand that time scarcity is the driving force. Increasing the number of “shots on goal” is the objective.
3) Focus on process over outcome
Hinkie made A LOT of trades to accumulate assets in the form of players and draft picks. Using historical statistics of Win Share, he typically received more value than he gave out in terms of salary cap or draft capital. However, many of his draft picks didn’t appear to work, at least not right away:
- Michael Carter Williams — traded after winning Rookie of the Year (smart move as his performance has declined each year thereafter)
- Nerlens Noels — Traded (bust)
- Jahlil Okafor — Traded (bust)
- Dario Saric — High-end NBA starter (good pick but played in Europe for a year after the pick and was perceived to be a poor pick by the media until after Hinkie was forced to resign)
- Joel Embiid — Superstar (This is the crown jewel. He was injured his first year.)
- Ben Simmons — Potential Superstar (To be fair, Hinkie didn’t draft him but he did make the moves to set the 76ers up to get the #1 draft pick in 2016 and Simmons was the consensus #1 pick. Simmons was injured his first year in the NBA.)
With any forecasts of the future, whether it be NBA players of companies, it is an exercise of probability and uncertainty. Just because there are bad outcomes, doesn’t mean the process is broken. If you stopped Hinkie’s process at any point before the 2017 season, it would appear that the process was a failure because the outcomes were suboptimal. If you examine the ongoing experiment today, about a year after Hinkie’s resignation, the 76ers have become one of the most promising young teams in the NBA.
Analogy to venture capital:
Earlier in my career as an investor, I often heard tall tales of how various senior colleagues were confident that various potential investments would turn out well. Despite the negative sentiment from the broader group, the partner “pounded the table,” got the deal done, and eventually made a bunch of money for the firm.
After 6 years of investing, I don’t think that’s what actually happens, and if it was, I don’t think that’s a healthy way to invest. There is no certainty when it comes to games of luck / probability. In fact, the more confident you are of the outcome, the more likely you have miscalculated the probability of the risks occurring. Uncertainty can be gut wrenching when you are putting your career and money on the line but without risk, there can be no convex outcomes. We must be comfortable with a range of potential outcomes and constantly learning how to be more accurate with forecasting.
The best possible outcome is to go through your process, make the right decision, and have a great outcome. However, if only 6% of the deals are REALLY right, then you’re likely going to have a lot of disappointing outcomes. The numbers imply that to find a big winner, a VC has to make a lot of right decisions before getting to one “right” outcome. The opposite is also true, and requires a lot of humility. You can make the wrong decision and get to a great outcome. This is probably the most intellectually dangerous thing to happen to a young investor and many old venture capitalists are still in the saddle due to this fortuitous mistake.
The magnitude of your correctness is more important than your frequency. Disappointing outcomes that result from a sound process will inevitably happen occasionally.
4) Have a long duration plan
The 76ers had to lose A LOT of games to accumulate the best draft capital. Sam took over the 76ers in 2013, and their record from 2013–2016 was a combined 47 wins and 199 losses, for a win percentage of 19%. Hinkie was willing to lose and be misunderstood in the short term, in order to win more games in the long term. All of that losing, and some savvy deal making, led to the 76ers becoming one of the most promising young teams in the NBA with potentially 2(!) generational superstars in Joel Embiid and Ben Simmons, and the salary cap to potentially sign Lebron James. They are the favorite in Vegas to win the LeBron free agency sweepstakes. The team made the playoffs this year with a 50 win season and at one point won 16 games in a row. Due to savvy trades, Hinkie also left the team with 2 additional top-end draft picks in the future, besides the 76ers own picks.
This is a quote from Sam Hinkie’s resignation letter that describes the benefit of having a long duration investment philosophy:
“More practically, to take the long view has an unintuitive advantage built in — fewer competitors. Here’s Warren Buffett in the late 80s on this topic: “In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” Ask who wants to trade for an in-his-prime Kevin Garnett and 30 hands will go up. Ask who planned for it three or four years in advance and Danny Ainge is nearly alone. Same for Daryl Morey in Houston trading for James Harden. San Antonio’s Peter Holt said after signing LaMarcus Aldridge this summer, “R.C. [Buford] came to us with this plan three years ago, four years ago — seriously. And we’ve worked at it ever since.” — Sam Hinkie
Hinkie really believed in the advantages of being a long term thinker and having a plan. He believed in it so much that he was willing to sustain ridicule and losses in order to achieve a long-lasting competitive advantage.
Analogy to venture capital:
In a competitive field like investing or basketball, working harder than the competition is not enough, one needs to work smarter as well. One major advantage that can be deployed is to make an honest assessment of the firm’s and one’s own personal unfair strengths that they can deploy, and weaknesses that can be mitigated or improved upon. Taking that into account, create a long-term plan for 1) the type of investor one wants to become, 2) the type of organization one wants to help create and 3) the types of companies one wants to invest in. Then build medium term and short term goals (and KPIs) that build into the high level goals. This was actually inspired by Angela Duckworth’s Grit:
I have this quote committed to memory as it is a constant reminder to accomplish my low-level goals:
“More important than the will to win is the will to prepare.” — Charlie Munger
5) Have courage
“There has been much criticism of our approach. There will be more. A competitive league like the NBA necessitates a zig while our competitors comfortably zag. We often chose not to defend ourselves against much of the criticism, largely in an effort to stay true to the ideal of having the longest view in the room. To attempt to convince others that our actions are just will serve to paint us in a different light among some of our competitors as progressives worth emulating, versus adversaries worthy of their disdain. Call me old-fashioned, but sometimes the optimal place for your light is hiding directly under a bushel.” — Hinkie
Analogy to venture capital:
The path to the next 10x return likely won’t be a popular one. It will likely be riddled with ridicule and skepticism, both from the broader industry, and also from within your very own firm. Have courage. Believe in yourself and the plan. Don’t be afraid of bad outcomes. Constantly tune your process and be willing to say, “I don’t know” or “I was wrong.”
“There are a few prerequisites to inventing…You have to be willing to fail. You have to be willing to think long-term. You have to be willing to be misunderstood for long periods of time.” —Jeff Bezos
6) Work with people who are aligned
Unfortunately for Sam Hinkie (and for the 76ers), he learned a tough lesson at the end of his tenure. As an agent, the expected duration of investments and outcomes should match with the principal (or equity owners of the 76ers). He was asked to resign before he could see the fruits of the winning season but was able to have the last word with a masterpiece of a resignation letter. He is one of the most celebrated sports figures in Philadelphia and he’s not even an athlete and didn’t manage the 76ers to a single winning season.
Analogy to venture capital:
This lesson applies to all investors. Most short-term games are so competitive that there is no longer any alpha (unless you want to compete with high frequency trading software). If you want to play a courageous long-term game, don’t take money from short-term oriented LPs. If you are a junior investor, you are an agent and the general partners are the principals. Work with partners who are playing a long game.
Venture capital is a competitive business and it will only grow increasingly so. What has worked for our older colleagues likely won’t work for us. The next generation of fund managers currently sweating away in the shadows and waiting for their turn in the spotlight, might find the lights turned off when they finally get on stage. This belief is probably more controversial, but I believe that one day in the very near future, we will look out from our castles on Sand Hill Road (or South Park these days) and realize that we were so busy instructing others to build defenses around their businesses, that we never bothered to build moats around ours. Venture capital has enjoyed both the literal and figurative fruits of the plentiful Silicon Valley, but the barbarians are at the gate and the land may not be as fruitful in the future. Only people who think they are going to be in the same castle 20 years from now bother to build moats.
How to play a winning venture capital game:
Make as many steep convexity investments as you can, where the company has many attributes of previous anomalous outcomes. Avoid time commitments that keep you from accomplishing your goals. Use all resources and forms of leverage (people, capital, software) at your disposal to create an abundance of time. Have deep humility such that you can continue to iterate and perfect your process. Have patience and trust “the process” enough to collect a sufficient number of data points. Keep learning every day. Work with great people who have a long time horizon and believe in you. Have a ton of courage. Never play a short game.
Best of all, have good luck.
Special thanks to Eugene Wei, Dan Hung, Chelsea Stoner and Becky Buckman who read early drafts and gave me great feedback.
