If you’re right about the entrepreneur, and you’re right about the market, you’ll probably make money.
I’ve spent my career as a venture capitalist trying to figure out how to get a higher hit rate from the investments we make. You only get a dozen or so deals in a small fund like ours, and we’re actively involved in each one. With this strategy, a partner can only do one to two new deals a year before he gets overwhelmed, so you quickly learn in the VC business to make every investment count. When you focus on a small town like Boulder, you get to live with your mistakes for a long time; every day, you see the consequences of your failures in the faces of local investors, employees, contractors and customers.
Venture capitalists generally like their jobs, whether or not they’re any good at it, because we’re control freaks. Ironically, being a venture investor in a startup company gives you a limited amount of control compared to other investment professionals. When you run a mutual fund or a hedge fund, you see the results of your ideas every day on the balance sheet. Even though you have no influence on the outcome, each day you can buy or sell the stock of the company you’re betting on — the ultimate in control (occasionally, cheating is a successful strategy for these investors, too).
Buyout investors own the companies they invest in, so they can change management and influence the timing and location of their exits. Mostly, they invest in operating companies that are valued as a multiple of cash flow. Compared to startups, there’s a lot of certainty investing in stable cash-generating businesses, which enables the financial engineering that is the basis of success or failure for the buyout investors.
In contrast, venture capitalists partner with entrepreneurs to conceptualize and create a novel business. Nothing is certain in a startup and while there are examples of success and failure for every business model we fund, each startup company finds its own path. In addition, and in contrast to hedge funds and buyout funds, we syndicate our investments with other investors who share our worldview and conviction, further eroding our control over an already chaotic situation.
Within this context, the lesson we have taken from our experience investing in startups is to focus on serial entrepreneurs, and on the size and trajectory of the target market — these are the keys to a high investment hit rate.
Serial entrepreneurs are a special breed and it is hard to describe what makes any individual great. We sometimes know it when we see it, but after our first experience with her, we can spot it every time. Knowing how to support, encourage, and stand beside a successful entrepreneur is the most important skill we possess as venture capitalists. I often tell our investors that nurturing an authentic relationship with our serial entrepreneurs is our most important duty and the source of value in our partnership.
We invest in companies that can create and sustain fast revenue growth. On exit, these investments are valued by the public and by strategic buyers based on revenue trajectory, not profitability. While it’s possible to create a fast growing company in an old market by introducing a better product, it’s much easier to do so in a new, fast growing market. Especially when selling to the enterprise, we make bets on markets and entrepreneurs rather than on specific products.
If you’re wrong about the size and growth of the new market, great entrepreneurs can sometimes change course (or get lucky) and still make money.
If you’re wrong about your entrepreneur, experienced VCs can sometimes change jockeys (or get lucky) and find success.
If you’re wrong about both, you get to lose all the money.
But when you’re right about the entrepreneur and you’re right about the market, it’s a beautiful thing.