1 Question, 3 Clues and 31 Lessons About Venture Capital (Part I)

Photo credit: Ricardo Viana via Unsplash

What’s the best way to learn about venture capital?

I recently gave a presentation about venture capital lessons to a group of family offices based in Asia. Given the audience, expectations were high and it was important to have a useful analogy rather than simply going through a checklist.

I was struggling before the event to find the right analogy.

In school, getting 30 correct answers out of 30 questions is excellent. And for something like operating a nuclear power plant, that’s very useful. As we’ve sadly learned, we don’t want to have any mistakes with nuclear power plants.

Unfortunately, our traditional education system isn’t very helpful when it comes to learning about venture capital.

In venture capital, one measure of success is a 5x net return for a fund overall. That outcome is possible even if only 10 out of 30 investments return more than 1x while some of those 10 are big wins. So being mostly wrong but being right big can lead to tremendous success. Pretty much the opposite of our traditional education system.

What about credentials?

This brings back memories of my days lost studying for the CFA exam. My wife still remembers it well because I went missing (studying) for several months every year during a 3 year period. Getting the CFA showed that I know how to work hard.

It’s a useful signal in some ways, especially in a noisy world where attention spans are getting increasingly shorter. But how useful is the knowledge I learned from the CFA for venture investing?

Not terribly useful.

Artificial intelligence is gaining momentum every day. And perhaps it is the ultimate solution.

But the timing seems early. There are so many other problems for AI to solve which are likely to happen sooner. And even if it does take over one day, the idea of a black box as an analogy can’t really help us become better venture investors today.

So the analogy remained a mystery even after thinking about the obvious models. I needed to search for more alternatives.

An obvious starting point is that venture capital requires hands-on learning. Yes, there are textbooks. But good luck learning about venture capital by reading textbooks.

Bungee jumping is similarly learning by doing. It also has risk. But if you make a mistake bungee jumping, you go SPLAT. That has more similarity to running a nuclear power plant than venture capital. So learning by doing is not specific enough.

We need something which allows for more creativity and tolerates some failure.

Painting comes to mind. That’s creative.

But would you want Vincent van Gogh managing your money? He might be a bit too wild. Maybe we need something more than just creativity.

So can we find something which adds discipline to increase the chance of repeatable success over time?

The clues point to martial arts.

I’m in the fortunate position to have some experience in both venture capital and martial arts. The more I explored the analogy, the more lessons I found.

The natural approach to this analogy is to start at white belt and work up to black belt.

Everyone starts as a white belt. Unfortunately, many people also finish as a white belt.

Of course some people simply don’t put in the effort. But it’s not just that. People are too busy. Family. Work. Cat photos.

This is also mirrored in venture capital. The key constraint is not money or brains, it’s time. People are too busy to find the time and effort to succeed in venture capital.

Everyone wants quality dealflow. The dirty secret of getting quality dealflow is that you can’t avoid the challenge of quantity. To find 1 venture capital investment, it’s very helpful to take a look at 99+ as a comparison.

Some days it does feel like venture capital investment creates a “master of no” skill set because we unfortunately have to say no so often.

Then if you start to get seriously interested in an investment, it’s not enough to simply go by gut feel. Statistics show that due diligence time spent has a massive impact on results (specifically, at least 20 hours makes a key difference. If you want to see the data, I can send it to you because I researched this myself — the last thing I wanted to do was waste time if it didn’t make a difference in results. It does).

It’s possible that your first angel investment will be a home run. It happened to John Wu. He’s a smart and fun guy and we were also fortunate to have him share his story at the same event.

But let’s assume that you’re not John Wu and you’re first angel investment won’t become the next Alibaba. That’s probably a reasonable assumption.

You really do need a diversified portfolio. At least 10 to 15 investments, more like 30. Then after you invest, the real hard work begins — helping your portfolio companies!

That starts to sound like a full time job. For a few people. And that’s because it is.

So if you’re serious about venture investing, you should be thinking about allocating the full time energy of at least one hungry and smart person, probably more than one, and even then you probably need a bit of luck to succeed.

And we’re just getting started with the white belt. Hard stuff, just like karate training…

…in fact, there is no shortcut in karate training. If someone promises you a black belt in 3 months, run away as quickly as you can. The time horizon of traditional karate training is long-term.

If someone promises you to double your money in 3 months from venture investment, run away just as quickly. On a similar note, I have a friend who raised money from new investors in a VC fund and unfortunately after 3 months one of the investors thought they could simply put in their redemption notice, like in a mutual fund. Whoops.

Technically, there is a secondary market in venture capital, but you should not expect they buy/sell spread for these transactions to be low cost, especially for anyone who is perceive to be a forced seller for liquidity reasons.

Of course, venture capital is not a monolithic category. There are important differences even within venture capital. The basic principle that can be applied across the board, as with other investments, is to align the time horizon and liquidity structure of the investment vehicle with the time horizon and liquidity reality of the underlying investment.

For an early stage startup that may take 10 years (or more) to exit, you should assume 10 years (or more) of investment. For a pre-IPO fund targeting companies to go public within 12 to 18 months, it’s certainly possible to have a much shorter-term liquidity structure. Both structures can fall under the definition of venture capital and so it’s important to be clear about these differences.

When you read about a karate teacher who has won a huge number of awards and trophies, that starts to be a negative sign because traditional karate has no competition or tournaments. Instead, look for a karate teacher who is focused on the underlying quality of the karate itself.

There are many startup competitions, awards and lists. While there are certainly some benefits at the beginning, they can quickly become a distraction.

If you are sourcing deals from these lists or famous co-investors, at best you are overpaying on valuation. At worst, the company may be using this fame to gloss over gaps in the underlying business. Like Theranos, for example. Awards are no substitute for happy customers and users.

A friend describes Fresco Capital as an “underground” VC firm and I like that description. We pride ourselves on finding underground opportunities. The key to this is having a diverse network. This starts by having a team with different experiences and skills united with shared values. We can then expand this across cultures and borders, both real and imagined, to look in as many places as possible for opportunities.

We’ve invested in teams from Stanford and teams who never went to college. We’ve invested in teams who have strong public speaking skills and teams who have strong accents when speaking. We’ve invested in multiple pregnant female founders. We haven’t yet invested in pregnant male founders, but we can’t rule out the possibility.

The best part of this diverse network is that everyone talks to their local network and once we’ve broken into a new group and built up trust, word spreads quickly.

In Part II, we’ll explore Green Belt lessons and beyond.