Venture Populist

The common and conventional wisdom of venture investing is populated with a myriad of musty and meaningless maxims that do little to develop due diligence deft. The list of utter untruths include little tarradiddles such as the purported prerequisite that a start-up must draft a comprehensive business plan when seeking financing (wrong), or that there must a clearly defined exit strategy (also wrong).

The often cited notion that the entrepreneurs have material amounts of their personal cash invested as “skin-in-the-game” is another feckless formula for evaluating venture opportunities. It’s bunk. My only private investment write-off in the last ten years was the result of backing a proven entrepreneur with a prior high-multiple liquidity event who put $12 million of his own money behind a good idea that proved to be beyond his ability to execute. An expensive lesson, but…school me once (shame on me).

The majority of the most compelling private investment opportunities originated from entrepreneurs that lacked the personal wealth to back their great idea. Sweat equity, career opportunity costs, an equity positon providing material upside incentive and personal sacrifice are generally sufficient substitutes for a founder’s flesh.

One of the more sophomoric shibboleths among venture investment evaluation criteria is the fictitious “first-mover advantage” (FMA). The naïve notion, which garnered its groupies during the dot-com delirium, suggests that the first entrant to a market space can fend off the followers and dominate the market for a material period of time. Fueled by VC funding and visions of carried interests, blind faith to this “first-to-market” fallacy financed many blow-outs and busts.

Fact is, for every Amazon where the FMA proved sustainable, there are dozens of examples where the market pioneer gave ground to a later entrant. There are only a few instances where the first mover held considerable market share (and developed material enterprise value) for a material period…such as Henry Ford’s Model T dominated the market for years until giving ground to Chevrolet.

The second mouse gets the cheese

My own experiences concur with this more accurate history of venture. I had a hand in the development of a multi-billion alternative strategies asset management firm that picked off the AUM of the first-to-market pioneer firms by developing cheaper, more transparent and more liquid investment vehicles. The pioneers spent vast sums on educating the marketplace. We simply piggybacked and poached the pioneer’s early adopter clients on the way to assuming a dominant market position.

In most cases, you are better off backing the entrepreneurs that are building the second coming of the next big thing. The slower but wiser entrepreneur for me.

Viola, Erwise and Midas, the first browsers, gave way to Mosaic, which in turn, gave way to Netscape. Chux, the first disposable diaper from J&J gave way to P&G’s Pampers. Micro Instrumentation & Telemetry Systems pioneered personal computing with Altair, which later gave way to Apple who hardly dominates the personal computer market today.

Microsoft succeeded not by being first. Digital Research developed the first desktop operating system. In fact, Softy purchased the original DOS program from Seattle Computer works for $50K. Easy to forget today, but back in the day Gates expertise was marketing, not innovating.

Visacalc, the first desktop spreadsheet program, gave way to Lotus 1-2-3 which in turn gave way to Excel.  Boeing did not pioneer the commercial jet, Disney did not introduce the theme park, Starbucks was not the first gourmet coffee shop and Wal-Mart was not the pioneer of discount retailing. They were not first—they were better.

Proponents of the FMA argue that the first entrant achieves name recognition, achieves economies of scale, locks in early customers due to consumer habits or high switching costs and develops brand loyalty…consequently building barriers to entry.

But, with the exception of truly proprietary IP or geographic advantages in brick and mortar or service industries, I don’t find those “advantages” to be sustainable by virtue of fiat. Better will always end up beating out first.

The empirical research bears this out. In the 1996 study, “First to Market, First to Fail?”, Gerard Tellis and Peter Golder demonstrated that pioneers are rarely rewarded for their efforts. Rather, they found that another class of firms labeled early leaders (the category of second and third-comers) enjoyed “a minimal failure rate, an average market share almost three times that of market pioneers and a high rate of market leadership.”

Thats because the first-mover pays a huge cost in R&D, marketing and advertising to educate and entice early adopter customers or clients. The later comers have the benefit of case study, market intel and the opportunity to sell relative value…often referred to as the “free-rider effects”, where late movers may be able to free-ride on a pioneering firms investments in R&D, consumer education and infrastructure development. These “imitation costs” are more vastly affordable than the “innovation costs” that often cause the pioneer to crash and burn.

When evaluating pre-revenue ventures, I find it best to eschew first-to-market business models in favor of the better, faster or cheaper followers. Look to who’s next. It’s easy to be sucked in by the intuitive appeal of the FMA, but I have already been schooled…I won’t get fooled again.

Album:   Who’s Next, The Who, 1971

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I have noticed that VCs tend to talk to the public and with their peers more about their home runs than their strike outs. Angel investors, on the other hand, prefer to relentlessly revisit their pain—often comparing their battle scars like veteran samurai. Probably because angels put up their own capital. Because they truly do eat their own cooking it’s harder for angels to forget their fallen soufflés.

VCs achieve their highs from the opium of OPM…so even a bad trip is still a free trip.

I recently had lunch with an inveterate venture investor (aka “angel”) whom I had co-invested with in a biotech, as well as, a med-tech company, several years back. Our conversation inevitably turned to peck at our past portfolios.

The biotech company was a true home run—a high-multiple exit realized in a 2004 IPO. (When was the last time you saw biotech, high-multiple and IPO in the same sentence?)

But, rather than relishing in a reminiscence of our raison d’être, we chose to get muddy in the mire of our miss—the medical device company that (nearly seven years later) was still trudging along with neither an exit, nor a write-off in sight.

There is the baneful scenario–five or more years in an illiquid private investment that just keeps rolling over but never plays dead, and, there is the painful scenario–a company running profitable for several years straight but no IPO, acquisition or distribution on the near horizon.

Two questions dominated our discourse. First, what would become of the med-tech investment? And secondly, what can we do differently as investors to avoid non-outcome outcomes in the future?

My most previous venture ovation opined, “There is very little that is binary about venture investing outcomes. It is not just feast or famine…outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater…”

That list of outcomes would be just fine if it was indeed comprehensive, but I employed some autistic license. The reality of the absence of binary outcomes in private venture investment occasionally includes the potential absence of any outcome at all.

In an amusing piece “10 Exits”, Angel Capital Association’s chairman John Huston further parses this purgatory. He evokes the venture vernacular “Zombie” as “a walking dead venture that will never become a great company, nor will it die so I can declare the loss.”

There are a number of ways to euthanize a zombie but what do you do about the investment that Huston calls, “My Grandkids’ Company…a company that is successful but there’s no exit in sight”? (“Maybe it will occur after my grandchildren inherit the portfolio.”)

That is the second question, and yes, there are methods that an investor can apply at the outset of the investment that mandate distributions from profitable private companies.

I have developed some effective term sheet and funding mechanisms that enhance the optionality of a private investment’s outcomes that avoid inadvertently gifting your grandchildren. I will share them in upcoming posts. They are the byproduct of my own experiences, and as you know, experience is what you get when you were looking for something else.

Album:   Hits and Exit Wounds, Alabama 3, 2008

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Contrary to conventional cliché, there is very little that is binary about venture investing outcomes. It is not just feast or famine. Rather, outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater on your initial investment.

What does appear to be binary is the manner in which prospective investors in private ventures perceive the asymmetric return profile of venture investment outcomes….most either adore it or abhor it.

On one hand, an investor like Jim Rogers is attracted to what he no doubt views as a positive asymmetric profile of venture investment outcomes. His venture acumen began developing at the age of five by selling peanuts and by picking up empty bottles that fans left behind at baseball games. In 1970, he co-founded the Quantum Fund. During the following 10 years the portfolio gained 4200% while the S&P advanced about 47%. Nice.

In a recent rant Rogers opined not only that “diversification was garbage”, but also went on to say that “you only need four or five good ideas in your life to get really rich”.

(Note that Rogers says “really” rich…which seems a bit elitist seeing as how only one or two good ideas can make one simply rich.)

Nevertheless, 90X returns over the S&P implies that he had very little fear of placing losing bets.

But what about those less adventurous souls that eschew positive asymmetric return scenarios in favor of more traditional investments with binary and symmetrical outcomes? Why are there so few angel and venture investors despite the compelling data of the asset class’ returns and the proven history of private enterprise as the single greatest creator of family wealth?

Economics psychologist Daniel Kahneman explained this behavior with his 1979 nobel-winning, Prospect Theory which describes decisions between alternatives with uncertain outcomes where the probabilities are known. In prospect theory, Kahneman identified Loss Aversion–people’s tendency to strongly prefer avoiding losses to acquiring gains. In fact, studies suggest that losses are twice as powerful, psychologically, as gains.

In their perpetual pursuit to mirror the risk-free rate of return, some investment advisors are factoring prospect theory and loss aversion into their asset-allocation schemes. But loss aversion studies opposing symmetrical outcomes…such as either winning $100 or losing $100. It provides little insight with respect to investor’s fear of positive asymmetric return profiles.

I prefer the wisdom in David Gal’s 2006 study, A Psychological Law of Inertia and the Illusion of Loss Aversion, which discounted loss aversion as “superfluous” and found instead that risk/return tradeoff decisions were decidedly “influenced by a tradeoff between the status-quo and change”. Gal calls it inertia, noting that that people will tend to remain at the status-quo when they have no clear preference between the status quo and an alternative option.

The rigid portfolio allocation to the same traditional asset classes within the same stale strategic asset allocation model is the status quo that Gal is referring to. The results have been far from compelling yet most investors, and their advisors, keep doing the same thing while expecting different results.

In a recent WSJ article, Jason Zwieg accounts for this “mental lazziness” that prevents  investors and advisors from challenging their status quo approach to investing (and consequently, not embracing alternative asset classes and strategies). “In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the confirmation bias…people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.”

Try Harder. Properly allocated, private equity and venture investors can materiality improve their portfolio’s risk/return tradeoffs and benefit from the proven superior performance of the asset class. But, expanding your repertoire by opening your portfolio to private investment opportunities requires commitment and effort to educate yourself on the rules of the engagement and evaluation.

Achieving superior returns by embracing private investment requires initiative…not inertia.

Album: Underachievers Please Try Harder, Camera Obscura, 2004

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One of the few commonalities among the thousands of VCs and angel investors is the consensus that the process of identifying an attractive private venture investment is “part art, part science”. The art part speaks to the inherent absence of certainty with respect to any venture’s viability. There are no absolute truths…no bankable checklist to follow that ensures a successful outcome for a private venture investor.

The science part? That’s simply hindsight, which of course is an exact science. Of the ways that I have derived knowledge as a private venture investor, hindsight is the most expensive, the least merciful and the most valuable.

When it comes to separating the wheat from the chaff, my primary screen is simple. For a private venture investment (PVI) to be worthy of the costly, time-consuming, bandwidth-bogarting process of evaluation, consideration, due diligence and deal term negotiation, it must initially meet these four criteria;

1.  There is a large market for the firm’s products or services

The size of the market must be material for a PVI to potentially achieve a high cash flow or high-multiple (positive asymmetric) outcome. The success of category-killer app, product or service in a small market lacks the potential of an exponential payoff and does not proportionately offset the risk of a loss.

Ideally, the market should not be merely mature—it should be a growing market. The market can be newly-emerging (alternative energy, for example) or non-existent (Twitter) at the point of the venture’s introduction of its product or service, but it’s potential must be measurable and meaningful.

The values set forth in the modern business classic Blue Ocean Strategy often come to mind. Blue oceans denote industries untainted by competition. In blue oceans, demand is created rather than fought over…competition is irrelevant because the rules of the game are waiting to be set.

I am predisposed to the notion that the initially contemplated product, service or business model rarely succeeds, and consequently ventures are frequently forced to adapt to new data points. This requires the room to maneuver that a large market provides.

2.  The firm has a sustainable competitive advantage

The venture must have a sustainable edge to attract and retain its market share. The location or lease of a real estate development can be an edge. The celebrity chef to a restaurant, the IP portfolio of a technology or medical device company or a strong distribution channel relationship can be a critical edge to a consumer product.

The more tangible, unique, defensible and proprietary the edge (such as patents)…the better. The competitive advantage should discourage competition and create a barrier to entry. The edge will vary according to the venture’s industry. First-mover status is often meaningless (like many others I prefer second-mover) and certainly not sustainable in a market of compelling size.

A sustainable edge to compete in a large market is critical to potential acquirers or public markets and the objective of realizing compelling multiples on an exit.

3.  The management team has compelling expertise in the contemplated market

You must have a great execution team. Visionary founders may be inspiring but they alone cannot bring a great idea home. Get an experienced and accomplished operator in early.

In a couple of my early investments I failed to hone this rule to its proper endpoint. Naively, I believed that the serial entrepreneur with prior liquidity events was a proven winner and worthy of the wager. The first time that formula fell short I failed to make the proper connection, the second time I learned the lesson. There will not be a third time.

Successful entrepreneurs too often become deal junkies fueled by the fumes of their prior triumph. Some become self-anointed business “generalist” experts (contradictory, eh?) that no longer feel restricted by the limitations of their actual core competencies.

The founding partners and management team must include an accomplished C-level executive or highly accomplished operator with a track record of proven experience with the specific business model and target market. Moreover, the operator must have the authority and discretion to execute the business plan. Serial entrepreneurial ego in the absence of domain expertise is a formula for failure.

4.  The deal terms are no less than fair, and ideally—favorable

Valuation, investor rights, board representation, management discretion and transparency with respect to material events, protective provisions, anti-dilution protection, liquidation preferences and optionality issues must incentivize and respect the source of the capital. The investor’s capital is the great enabler… the sine qua non for any venture.

Few things are as humbling as the successful venture that does not translate into a successful investment. I respect the often repeated axiom that a fair deal is one where both parties feel that they got a bad deal, but the end game should always be to negotiate favorable deal terms.

The probability of an attractive outcome is diminished if a private venture investment cannot meet these initial thresholds. In VC-speak you are nursing a newborn “zombie”…a walking dead venture…the ship is already sinking and it has not even left the port.

Album:   We Were Dead Before the Ship Even Sank, Modest Mouse, 2007

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