Embracing experimentation in VC

Last night I’m minding my own business, just trying to wind down, and I read this from two of my favorite people in the venture business in my Twitter feed:

There is a lot to unpack here. It gets to the root of one of my frustrations with the evolution of the venture business, which seems to shun risk in favor of either portfolio construction tactics (cast a VERY wide net in order to snare the elusive Unicorn that actually exits) or increasingly later stage, quasi-PE investing.

Neither of these, to my way of thinking, is actual risk-bearing venture capital, where conviction, capital and commitment intersect to either create important, disruptive, valuable companies or failures (but not for lack of effort or engagement).

Sure, during my time in derivatives and trading I was always on the look-out for the “riskless option”, that rare event where it’s possible to lock-in guaranteed value without bearing ongoing exposure.

That said, I see lots of activity across the venture scene that while not explicitly trying to secure such an option (which simply does not exist), reflects an attitude of risk-aversion that seems both out-of-step with the intent of venture investing and unlikely to generate the kinds of returns that reflect the risks (whether desired or not).

How’s a Company Built and Funded?

Something is broken here, and I think it reflects a fundamental misunderstanding of what is happening between the birth of a company and a Series A round — experimentation. And companies that are birthed require the capital necessary (generally ~2 years) to run these experiments to see if they deserve to raise a Series A round.

What constitutes “deserving” to raise a Series A round? Demonstrated product/market fit.

To be clear, correctly assessing what is scalable product/market fit versus fit of lesser quality is the difference between a meh exit and a potential grand slam, which is why there are good early-stage venture funds and the top decile funds. To wit:

But even being clear that from birth to Series A is about experimentation and achieving a Series A is a function of achieving a measure of product/market fit is a step in the right direction. Seems easy enough, so where is the rub?

The rub is that the amount of time and capital required, and the risk and effort to go from birth to Series A, doesn’t neatly fit within a single investor type.

The Second Turn of the Crank

To be honest, this is pretty much where we live at IA, but I’d say there is healthy amount of cynicism about our model, particularly among the Micro VCs who largely sit in between Friends and Family (F&F) and angels, and Series A firms. The principal argument is that our portfolio is too concentrated (read: too risky) to yield the Unicorn necessary to make it all worthwhile, but we’ll just agree to disagree and to let the realized returns do the talking.

But to Jerry’s point, there is a gap for what I’ll call “second-turn-of-the-crank seed capital”, where F&F and even Micro VC money has been taken, but more capital is needed to help run the key experiments necessary to demonstrate product/market fit.

There is no natural player in this space.

Besides IA, who will do everything from the F&F through the Series A as part of our institutional seed rounds, I think Bullpen may be the only firm I can think of that explicitly plays in this intermediate pre-Series A space.

To Bryce’s point, there just isn’t much true risk capital sitting in this zone, which means a bunch of companies that likely warrant more time to prove their hypotheses will either get jammed by adverse terms or not get funded at all.

Part of the problem is that to be comfortable taking second-turn-of-the-crank risk, you probably need to have been involved and engaged pretty much since the beginning, as knowledge of the team, its dynamics and ability to execute is key to being ok with writing another check. But F&F and angels don’t have the liquidity or risk tolerance, and many if not most Micro VCs suffer from the same constraints (or, if you believe Bryce’s hypothesis, scared about the reputational risk of going deeper into a potential failure).

So what you’re really talking about are firms that have the risk appetite, capital, time horizon and bandwidth to help support companies during the risky and complicated experimentation phase, from birth to Series A.

And there simply aren’t too many of those.

I can think of one. Perhaps Floodgate, Forerunner, others?

Bottom line, I believe the problem Jerry raised is a structural one, where there aren’t enough firms with the skill sets, orientation, capital and temperament to carry companies from ideation to product/market fit to commercialization. More of these should exist.

As for those playing in segments of this birth-to-Series A life cycle, it’s not clear to me that the critical dependencies on other sources of capital to bridge the gap when bridging is necessary to run the critical experiments is sustainable or desirable.

While it may seem less risky to make a wide array of option-type bets and hope that additional capital doesn’t crush you in times of duress, I believe the converse is true. Time will tell.