The Art Of Making Good Investment Decisions in VC
VCs can make spectacular returns. Sequoia Capital banked $3bn from its $60m investment in Whatsapp. Lightspeed Venture Partners turned $8M into $2Bn when it exited Snap. And SoftBank’s initial $20m investment in Alibaba was eventually worth $60bn when the company was listed on the stock market – that’s an incredible 3000x return.
How do they do it? Do they have access to information the rest of us don’t? Have an outsized appetite for risk? Or is it just down to pure luck?
While all those form part of the story, achieving consistent returns in any asset class is far more complex than most people imagine. The layers of people, planning, process, and analysis involved have been summarised well by the Economist and former CEO of Norges Bank Investment Management (known as the Oil Fund), Knut N. Kjær, in his recent speech and paper, The art of making good investment decisions. In venture though, the process is even more multi-faceted.
Often considered the ‘ugly duckling’ of all asset classes, VC is allocated the least capital but arguably requires the most work to deliver strong returns. Yet, the VC profession has proven its worth by funding some of the largest companies in the world and having a major impact by backing new technologies. As I’ve argued before, VC is the original impact investing – backing innovative solutions that will challenge and improve products and industries, thus benefitting society.
So, what does it take to succeed in the art of VC investing?
Operating at the cutting edge of science and technology, VCs must have an insatiable appetite for learning, and a deep curiosity for new concepts, technologies, people, and systems. Venture is about finding new solutions to problems, to make businesses, industries, and the wider world function better. That requires an ability to think deeply and critically about the problems that exist in the world and a consciousness of the need to evolve – to stay ahead of the curve. What is changing in how people live and do business? What gaps and needs are emerging? How can new or existing technologies help to fill those gaps? That is the space that you’re working in as a VC, and you can never be satisfied with the status quo.
VCs are by their nature optimists but that mustn’t come at the expense of managing downside risk. The entrepreneurs we back are a special breed who take a leap, often without any fear or risk assessment. If they spent too much time thinking about the downside, they probably wouldn’t do what they do. Most startups will fail and VC funds often make the majority of their returns from just 20% of their deals, which highlights the chance of getting it wrong, even for experts. So, it is our job to ensure we’re constructing a portfolio to achieve risk diversification to avoid being exposed in the event of economic or regulatory shifts. That means continuous learning and networking across several areas, to maintain the strength of knowledge and deal flow across diverse sectors and business models.
Investing in people as well as companies
Early-stage companies grow and evolve differently, but the ones that turn out the best are typically the ones with the best entrepreneurs. Most startups will pivot at some point during their growth journey, so while the original idea is important, you also need founders with the resilience and vision to overcome bumps in the road.
Thus, people are key, more than in any other asset class, and as a venture capitalist, we need to select best-in-class entrepreneurs. Through experience, you become skilled at spotting the individuals that have what it takes, who combine the visionary with the practical, the self-confidence with the humility, plus the interpersonal strengths to build and motivate a team and manage stakeholders. You learn from experience that second-time founders are sometimes a safer bet, as are founding teams (one or more founders), where there is a complementarity of competencies across the group.
Picking the best entrepreneurs involves spending plenty of time with them during the due diligence process, as well as doing peer referencing. You need to get an idea of how well they cope with adversity, and how they interact with those around them. At a more personal level, you also need to check whether there is a chemistry fit. Can you work effectively with these people for the next five or more years?
While the team is critical, VCs must also fight the FOMO (fear of missing out), so they have time to analyze the premise of the business idea, and not take founders at face value. Cases such as Theranos, and more recently FTX or Frank, show that founders aren’t always what they seem, and can sometimes be “economical” with the truth. As an investor, it’s easy to be charmed by a persuasive founder and fail to question basic assumptions. But getting caught up in hype is the enemy of good investing.
VCs must have the courage of their convictions but also the presence of mind to do their due diligence properly. In contrast to investing in more established businesses or the public markets, venture investors don’t have the same level of information to work with regarding trading history, market opportunity, or potential risks. Investors need to be skilled at asking the right questions and becoming knowledgeable about the sector in a short space of time, while also building a team that can support with analyzing the finances and the legal elements of a deal.
Another big difference between VC and other types of investing – and critical to the art of venture – is how we work with companies post-investment. In the early days, startups have a lot of issues and need support across numerous areas, from recruitment to business development, product positioning, fundraising, HR, and operational setup. Part of our job is managing downside risk by adopting a hands-on or activist role to reduce negative developments or probabilities. We need to figure out how we can augment and support the entrepreneur when they are entering the growth phase of a company or product. That means drawing on our own experience and expertise, and nurturing an extensive network of subject matter experts, to help protect ourselves from negative outcomes as well as emphasize and drive positive developments.
The art of venture investing isn’t a solo endeavor. As with any successful business or sports team, you need to integrate great talents and minds into your system, while building a continuous performance culture to deliver premium returns. Successful investing means empowering employees to speak up, bring ideas to the table and have the confidence to follow through on their convictions.
It means eradicating complacency; by all means, celebrate and share wins, but then move on and pursue the next target, applying the lessons learned in future deals. A venture team needs a system of accountability, to ensure that all members perform, while also accounting for the different ways that people work, interact and their varied strengths and weaknesses. Integrating and retaining different individuals behind a common goal is a skill, which takes leadership, guidance, and motivation. But without it, you’re unlikely to succeed in venture for the long term.
What makes a good venture capitalist?
Within the last few years, the venture capital profession has been ‘romanticized’ and over-simplified, leading to professionals entering the industry for the wrong reasons. The truth is, venture capital is hard work, and you need to have full conviction about yourself, the industry, and many other factors when pursuing a career in the sector. Not everyone is cut out for venture. Large workloads, dealing with uncertainty, and being faced with constant problems means that you need to have the right mentality and personal drive to pursue this as a career.
Background and qualifications are less important than personality, hunger, curiosity, and attitude. VCs must be highly resilient. You will spend your time juggling significant workloads, with numerous demands on your time. Relationships are critical on the one hand, but you must always know when to say ‘no’ in a respectable but expedient manner.
Perhaps most importantly, it’s vital to remain humble towards all your stakeholders, colleagues, investors, support staff – and particularly towards entrepreneurs. We see 2,000 to 3,000 companies per year, of which we eventually invest in around ten. But we must always remember that entrepreneurs are making the real sacrifices, in terms of the time, money, and effort to build a company – and ultimately realize their dream.