The Art of VC: Kissing a Lot of Frogs

When my friends ask me what I do, in my more quixotic moods I respond “kiss a lot of frogs”.  Right off the bat, let me apologize to all entrepreneurs for categorizing them as amphibious (I know VCs are tainted with less favourable animal analogies) but I figure that this is an accurate and memorable way of describing one of a VC’s core activities – deal flow.  The term “deal flow” has entered the common vernacular, at least in Silicon Valley, and although I dislike the phrase given some of its implications (“deal” implies a transaction rather than a relationship; “flow” implies the “deals” flow past you rather than you needing to go find them) life’s too short for me to try and coin a new phrase, so I’ll stick with it.

The Importance of Deal Flow

As I argued in my previous article “ The Art of VC: Picker or Builder?” the activity of building your own network of people who shall refer deals to you cannot be ignored, regardless of whether you pursue a picker or builder strategy. 

Let’s return to the simple model of returns I discussed in that article and assume annual returns for the four quartiles across the universe of venture investments are -100% (i.e lose all the capital), 0% (i.e just return capital), 20% and 40%.  Further, let’s also assume each investment lasts 5 years and each investment takes the same amount of capital, say $5M.  If an investor gets a “random” selection (and we ignore his ability to “pick”; the impact of compound interest; and his ability to improve the outcome post investment) then he would invest $20M and return $30M ($0M+ $5M + $5M*(1+(0.2*5)) + $5M*(1+(0.4*5)).  Now the problem with this example is that it assumes that the default is a “random” selection.  This is a false assumption because some VCs by virtue of their reputation and relationships shall have access to higher quality deal flow than a “random” selection.  Conversely, VCs who just sit in their office and wait for deals to come to them shall get an adverse selection.  For example, let’s assume such an investor never gets to see deals in the top quartile and so his distribution is 1 in the 2^nd quartile, 2 in the 3^rd quartile and 1 in the 4^th quartile.  Then he would invest $20M and return $20M ($0M+ $5M*2 + ($5M*(1+(0.2*5)).  So the practice of generating deal flow can be the difference between making positive returns and no returns given the distribution of returns in the venture business.  Remember, this says nothing about your ability to discern a good investment from a bad one, but just your ability to get access to the full spectrum of deals.

Putting the economics aside, there are other reasons why a VC needs to dedicate time and effort to creating and managing deal flow.  Rather than list them all, I would just like to highlight that deal evaluation is not a science but an art.  You get better at it the more you do.  You need constant practice.  You get better over the course of a career in honing your evaluation skills, but you will also have peaks and troughs if you do not dedicate time to this practice in a constant conscious manner.  YoYoMa has become a better celloist over the course of his career.  But if he doesn’t practice for a month, he gets worse.

Creating and Managing Deal Flow

So if you buy that actively spending time on creating non-adversely selected deal flow is important, then two pragmatic questions arise.  How do I create deal flow and how much time should I spend on it?

Having observed my fellow VCs it seems that there are three main approaches to creating deal flow

1. Tracking entrepreneurs.  Activities can range from sponsoring events at universities to spot the next generation of entrepreneurs, to courting experienced entrepreneurs before they have embarked on their next venture.  Many VCs institutionalize this process with their Entrepreneur-in-Residence programs.

2. Tracking VCs.  Many VCs acknowledge that they are not going to be able to attract the top tier entrepreneurs in the first round of funding, so they set their sights on investing in the second or third round of funding.  Consequently they target building relationships with the tier one venture firms so that when their portfolio companies are about to raise their next round, they are top of mind for the VC.  Some venture firms have institutionalized this approach to the point where they think of their “customer” as the top tier venture firm and not the company.

3. Tracking markets. This approach is more investment thesis driven where you evaluate the structure of an emerging market and the opportunities for startups to address customer needs.  You then spend time at industry conferences testing your hypothesis, debating with management teams from established companies in adjacent spaces, understanding the product roadmaps of the incumbents and seeking out entrepreneurs with a similar vision.

My approach is predominantly based on tracking markets.  This is a harder strategy to execute than the other two approaches – markets are much more nebulous than entrepreneurs and VCs – but I strongly believe it gives me the best chance of creating non-adversely selected deal flow.  I do incorporate elements of the other approaches – tracking entrepreneurs and VCs – but only within the markets I have selected for tracking.

So how much time should a VC dedicate to this activity?  My analysis, both from a top down and a bottom up perspective, suggests that 20% of my time should be allocated to creating and managing deal flow. Half of this time is laying the groundwork by attending conferences, sharing perspective with fellow VCs and refining investment theses.  The other half is meeting with startups to find the 1 or 2 investments I shall make each year.  My goal is to meet with 50 to 100 startups a year, so 1 to 2 startups a week.  That may seem like a high number but it’s driven by my observation that it’s not possible to evaluate a startup’s business plan without meeting the entrepreneur in the flesh.  For a first meeting I like to dedicate 90 minutes to give the entrepreneur a chance to tell his or her story and for me to challenge them on their assumptions and future plans.  I am looking for entrepreneurs who can connect the dots between customer needs, the economics of building and delivering a solution and the evolving competitive forces.  I want someone who can understand their customers but translate that into dollars and sense (I do mean sense not cents). This time commitment, coupled with giving feedback to the entrepreneur, equates to about half a day a week.  From these first meetings less than 10% result in a second meeting, so the bulk of the time is in those first meetings. 

Getting to “No”

One of the many failings of VCs that you will often hear from entrepreneurs is that they rarely receive a definitive response after making a pitch.  I can understand their frustration at this “death by a thousand smiles”.  The reason for this is that most VCs think there is no downside to not giving a definitive response.  My former colleague Bill Burnham has written on this topic.  I think this approach is short-sighted and misguided and that is it in the best interests of entrepreneurs and VCs in getting to “No” as quickly and clearly as possible.

Let me explain why I take this stance. 

1. VCs are in the service business.  With venture capital in more plentiful supply than successful entrepreneurs to back, VCs need to acknowledge that we are in the service business.  VCs can differentiate themselves with entrepreneurs with the speed, quality and thoughtfulness of the feedback they provide.  One metric I track for my own deal flow is the time taken to get to “No”.
   
   

2. Managing the bulk of your deal flow time. Given that I will make only 1 to 2 investments a year this means that ~98% of the meetings I take shall not result in an investment.  If I allow these deals to stagnate in my deal flow, I become less productive.  There is considerable evidence that uncompleted tasks can be a drain on productivity.  If your time for getting to “No” is 1 month rather than 1 week, then the amount of uncompleted tasks clamouring for mental attention is fourfold and you have a resulting decrease in productivity.
   
   

3. Experienced entrepreneurs respect thoughtful feedback. If respectfully delivered, I don’t believe a “No” will ever preclude a future opportunity to invest.  Conversely, entrepreneurs that take “No” badly probably won’t be successful.  One metric I track is how many “No’s” lead to not having an opportunity to reassess an investment at the next round.
   
   

4. Entrepreneurs talk to other entrepreneurs.  The old saying that happy customers tell one other customer about their experience, but that unhappy customer tell ten other customers about their experience, may well be true of entrepreneurs.  Just as entrepreneurs have reputations among VCs, so VCs “earn” reputation among entrepreneurs.  Many of the deals referred to me come through entrepreneurs to whom I have said “No” in the past.

Giving quick, specific feedback to entrepreneurs and then giving them an opportunity to respond is difficult to achieve but I shall continue to strive to do so, both because it will make me a more successful VC and be beneficial to the entrepreneurs with whom I have the pleasure of interacting.  As Alexander the Great said “Remember upon the conduct of each depends the fate of all”.  Given he conquered the known world by the age of thirty three, I would do well to heed his advice.