The answer, of course, is timing.
Every VC has an internal model for what makes a good a priori investment. Historically the dominant model has been to back an engineer or CEO with whom you have personally worked in the past and know to be driven, trustworthy and competent. This model partly became dominant because the profile of the typical VC has been a 20 year technology executive who has a large rolodex of previous colleagues and thus a large universe of potential deals. The focus on the market has been secondary; the founder/CEO or technology has been the primary focus. It’s still a truism that a top tier VC rarely makes an investment where there was not a pre-existing relationship (or only two degrees of separation) between the founder or VC. I think a rigid adherence to “I don’t do deals coming over the transom” is a mistake for a VC unless you have a vast network with weak ties. Venky Ganesan from Globespan (and fellow board member at Sendia) has written an interesting perspective on this based on a talk by Malcolm Gladwell we both attended last year.
This model of relying on an entrepreneur you know has been challenged over time to the extent that most VCs when evaluating an investment now think about five criteria – the experience of the team, the level of differentiation and defensibility of the technology, the attractiveness of the market, the business model and the price of an investment. When I hear most VCs discussing an investment (either current or potential) they seem to place equal weight on these criteria. I think this “checklist” mentality is wrong. When I am evaluating an investment I place a disproportionate amount of effort into understanding the market as I believe this is the largest determinant of investor returns.
So why do I believe market timing is the largest determinant of investor returns? And if so, how does this belief change my actions as a VC?
The majority of venture returns (as measure by invested capital) are likely to be made through being acquired, not through successful IPOs. To be an attractive acquisition the startup will need to have identified a white space that incumbents have not yet addressed and executed faster and better than the competition. The acquirer will be doing the calculus on whether it is better for them to a) ignore this market b) address it with their own product or c) acquire a company who is already ahead of them. The main determinant of them choosing c) over a) or b) is that the rate of the market development is fast (they cannot get a solution to market quickly enough by developing their own) and attractive (they are allowing their competitors to claim the available profit). The quality of the management team and the superiority of the technology will count for nothing if the market does not demonstrate the right vector. This does not mean I don’t value experienced management teams and deep technology; but rather I will always evaluate them through the lens of market development. Does the management team have a track record of identifying market needs and executing against them faster than the competition? Does the management team understand the current solutions in the adjacent spaces and how quickly they could reorient their solutions to be competitive? Does the management team understand who the natural owners of their business shall be in the future? Is the number of buyers (incumbents needing solutions) likely to exceed the number of sellers (startups)?
So given this belief in the importance of market timing, how does this impact how and where I spend my scarcest resource, i.e. time? As I wrote in my previous “The Art of VC” article, it’s important to be conscious how you want to manage your deal flow so you avoid adverse selection. Given my belief about the paramount importance of judging market timing, I manage my deal flow in three ways.
- Focus. At any one point in time I have 2-4 chosen areas of focus. These are working hypotheses that I review every quarter and consciously adjust based on new data such as product announcements and new fundings. I believe I need to understand whether a market has the right characteristics that will give a startup the chance to be a success given the inherent advantages of the incumbents, before I can evaluate any individual startup.
- Immersion. Once I choose a sector I try and immerse myself in it to gather as many diverse data points as possible so I can start to do my own pattern recognition. I want to understand the roadmaps of the incumbents, their propensity for buy vs build, how conservative or aggressive their management team is, who makes the buying decision, what are their alternatives etc. The mental model I have for understanding the pace and rhythm of a market’s development is based on a Roman gladiator’s training wheel (you can see Kirk Douglas use one in the movie Spartacus). This was a vertical wooden pole with the top half and bottom half rotating in opposite directions. On the top half a horizontal pole was at head height; on the bottom half a horizontal pole was at ankle height. A gladiator would use this training wheel to learn to duck and jump opponent’s blows. I have actually had the opportunity to try one of these training wheels at a Roman museum in the south of France. My experience went through three phases. First, when you observe someone else jumping and ducking it looks very simple. Second, when you first try yourself you get whacked around the head and ankles because you cannot internalize the rhythm and make adjustments quickly enough. Third, once you have the rhythm it is easy to maintain. This easy-hard-easy transition is similar to understanding a market’s pace of development. From the outside it easy to make judgments and high level observations. However when you are in the midst of the action the realities become more apparent such as customers' reluctance to switch vendors and the tactics of the incumbents.
- Patience. The shape of market development is not linear, but follows the classic S-curve which is broken down into three phases. The first phase is a long development ramp with a shallow gradient where the rate of change is slow. For example, consumer VoIP has been on a slow ramp since the mid 1990s when PC-to-PC calls where first possible. But now that we have carriers offering wholesale SIP termination, the cost of entry and experimentation is low and we are entering the second phase of rapid growth where the gradient is much, much steeper but also shorter before we move to the third stage of market maturity where the gradient flattens off again. My goal is to invest as close to the end of the first phase, before the second phase is readily apparent to every casual observer and this has been fully priced into the valuation. While this sounds laudable, it is very difficult in practice. After all the definition of the first phase is a long ramp with a constant low gradient so that if all you can "see" is the part of the ramp immediately before and after you, there are no clues as to how close you are to the second phase. I deal with this by getting immersed in markets early and gathering the data to build the pattern recognition. This runs counter to the "hot deal" mantra of most VCs - you see a great deal (as defined by the team/technology), you jump on it. In one example I tracked a company for 2 years before making the investment. Patience is a difficult virtue to espouse in VC because of the "hot deal" mentality.
I realize that my approach is different from the majority of my colleagues, but the business of VC is experimentation. That said, I keep in mind the words of the Democratic Presidential candidate George McGovern. He said "You know, sometimes, when they say you're ahead of your time, it's just a polite way of saying you have a real bad sense of timing."