On Due Diligence and Decision Making: Venture Capital

December 8, 2015December 7, 2015 / Nathan Guo / Leave a comment

This week, I am continuing a series of posts on due diligence and decision making across different asset classes. Here’s the link to see the first post in the series on poker as an asset class: Link

Due diligence varies substantially across asset classes, and I believe that different investors are better or worse suited for investment in different assets based on how characteristics of asset class decisions match an individual’s personal preferences. I will continue to use the overall framework developed in the last post in order to analyze the decision characteristics of venture capital (VC) against that framework. I’ll end with analysis of the due diligence performed in VC, and discuss the typical investor traits necessary to be successful in VC.

Framework

Based on my experience, there are 7 decisions characteristics that I believe inform how these decisions are made and subsequently whether you are suited for due diligence of an asset class:

Frequency of Decisions: How often are decisions made?
Distribution of Outcomes: How good or bad can the outcome be? Do outcomes follow a normal distribution or a power law distribution?
Length of Decision Impact: How long lived is the decision? (e.g., venture capital firms might hold a company for a decade, while high frequency traders might hold an equity for a fraction of a second)
Decision Uniqueness: How similar is this decision to other decisions?
Stakeholders: Who benefits or loses from this decision, and how are their motives aligned?
Accessibility to the Public: How easy is it for someone to access this asset class?
Ownership of Outcomes: Who is taking the risk?

Decision Characteristics of Venture Capital

My analysis will center on early-stage venture capital, which is the only segment I’ve had experience in. The later stage you go in VC, the more the asset class looks to private equity, and eventually public equity investing.

Frequency of Decisions: Sourcing decisions happen daily for VCs, whereby they say no to spending time on startups. Actual investment decisions are relatively few, with most partners leading an average of 1-2 investments per year.

Distribution of Outcomes: Venture capital investments exhibit power law behavior, as pointed out by many prominent VCs such as Peter Thiel. I am not privy to VC returns, although some such as the Kauffman Foundation have published copious data on returns to help triangulate. Below is my approximation of how outcomes look in VC as compared to poker for an individual professional poker player or a partner at a VC firm.

There are several conclusions and assumptions embedded in this drawing:

Assumption: The Y axis is not drawn to scale. Professional poker players have hundreds of thousands of hands to draw from, while VCs might reach 100 investments over a very long career. If plotted on the same Y axis, the VC distribution would be barely visible, since there are so few actual investments
Assumption: The X axis is logarithmic
Assumption: The distribution I’ve drawn is a somewhat idealized view of VC that follows a J-curve. Some critics of venture capital including the previously linked Kauffman report have shown that there are a variety of variables that can have strong impacts on return distributions, including things like vintage year, fund quartile ranking, and others. It’s likely that many VC funds out there do not exhibit the positive power law behavior distribution illustrated above, and have instead a somewhat negative normal distribution.
Assumption: These are only the company outcomes, not the VC partner’s actual outcome distribution
Conclusion: While poker exhibits negative power law distributions, VC exhibits much more of a normal distribution on the downside, and a power law distribution on the upside. VCs have relatively frequent, large, negative outcomes due to the fact that so many startups fail
Conclusion: VCs (or at least ideal VCs) have a longer positive tail of outcomes than poker players do, with several orders of magnitude larger positive outcomes ($1B+ vs. $1M+)

Length of Decision Impact: Active VC investors may live with their investment decisions for a very, very long time. Good VCs with a board seat are engaged with their portfolio companies on a day-to-day basis beyond attending meetings once a quarter. The Kauffman Foundation reported many funds have not fully unwound positions more than a decade into the future. Thus, the impact of an investment decision is substantially longer than say poker or sales and trading.

Decision Uniqueness: Decision Uniqueness is extremely high for VC, with each investment having different people, products, and industries. While some VC firms try to specialize to some extent, the decisions still look very different from one deal to the next. It’s incumbent upon VCs to do their own homework and be familiar with a portfolio company’s industry if they hope to have even a chance of adding value.

Stakeholders: VC investments have a very complex set of stakeholders. VCs have both a fiduciary responsibility to the investors (also known as limited partners or LPs), and a fiduciary responsibility to the shareholders of the companies (including founders, employees, and other investors) whose boards they sit on. These stakeholders tend to be more aligned when things are going well, but things can get more complicated if things are going poorly.

Accessibility to the Public: Most VC deals are extremely proprietary, and limited to a small handful of investors. Prior to the adoption of Regulation A+, investing for individuals was limited to accredited investors. Although Regulation A+ has expanded accessibility to venture capital, it’s likely that the best deals will still be proprietary to a handful of VC firms, and mostly inaccessible to the public.

Ownership of Outcomes: Traditional VCs invest someone else’s money, typically money from their Limited Partners (LPs). Although management fees can help reduce VC reliance on carried interest as a salary, Jason Lemkin and others have written about how the capital contributions that General Partners (GPs) are required to put in to help align incentives with the LPs can nullify the salary you get through management fees. This means that VCs have relatively large ownership of outcomes, since they are giving up a substantial amount of immediate cash flow for hopefully large, future carried interest cash flows.

Due Diligence and Investor Traits in Venture Capital

Although venture capital is often compared to poker, there are a number of decision characteristics that dramatically affect how due diligence is performed, and what traits to look for in investors. The relatively small number of investment decisions coupled with the very long 10+ year decisions means that VCs are very “all-in” with individual investments, much more so than a poker player who plays many hundreds of thousands of hands a year. Thus, VCs must be very long-term focused, and willing to be patient and wait for out-sized results far in to the future.

The distribution of outcomes for VC investments also has a substantial impact. Because so many startups ultimately fail, and the fact that 1 or 2 portfolio companies could make or break a fund, VCs really have to swing for the fences with every deal they take. This is in heavy contrast with poker, where professional players are focused on squeezing small edges over a large number of hands. On a day-to-day basis, sourcing tends to be focused on finding reasons to say yes, with a key question being whether or not a startup can make it to the far right end of the power law tail. VCs attempt to filter through hundreds of startups and founders a year to get to 1-2 ultimate investments. As a result, VCs say no to spending more time on startups on a daily basis, often with only a light amount of diligence. While this does mean that they sometimes say no to great deals, this is largely a function of the frequency of decisions and distribution of outcomes.

For those startups that DO make it through the sourcing funnel, VCs perform due diligence in a very different manner than later stage private equity investors. Because the decision uniqueness is so high in VC, there are usually few if any comparable companies or products. This makes it nearly impossible to accurately forecast the future trajectory of the company. This stands in stark contrast to later stage private equity deals, which generally involve companies with tens or hundreds of millions of dollars a year in real revenues and profit. Private equity stage companies have a relative dearth of information available to analyze to assess the potential of an investment. Little data usually exists for many startup markets, and VC diligence tends to be relatively qualitative as a result.

While people of many backgrounds ranging from finance to journalism have succeeded as VCs, I have seen a few common traits among the VCs I’ve met:

Long-term optimism: While some like Founders Fund push the envelope on the pessimistic side, allocation of capital in wait of very long-term, future outcomes requires a high degree of optimism. The way the numbers work out, VC partners are very all-in
People-focused: The challenge of filtering through hundreds of startups and founders a year to invest in 1 or 2, means that VCs speak with tons of people on a daily basis. This task is not onerous given that most of the people you are speaking with are bright, passionate founders, but it’s certainly not for everyone
80/20: Despite only making 1 to 2 investments per year, VCs tend to make very frequent decisions on a daily basis, about where to invest their time. In addition, because the outcomes being chased are so far in the future, it’s near impossible to get 100% of the truth today. Thus, VCs are constantly trying to filter between signal and noise, and they need to be able to get to 80% of the “truth” quickly to decide whether they should continue to invest time in a startup or a founder.

It’s clear that while there is overlap between poker and VC, there are some decision criteria that dramatically change how due diligence is performed, and subsequently who is best suited for each. For more insights specific to VC, check out my previous post, What I Learned About Venture Capital This Summer, which goes more in-depth into who is best suited for VC. Next week, I’ll dive into private equity to attempt to tease out why it looks so different from both VC and poker, despite the fact that VC is technically a subset of private equity.

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What I Learned From My First Board Meeting

October 6, 2015October 6, 2015 / Nathan Guo / Leave a comment

Recently, I had the pleasure of attending my first board meetings ever. Thanks to Bilal Zuberi, Partner at Lux Capital, for having me along and answering all of my questions about board dynamics and effective leadership – your continued advice and support are really appreciated and invaluable.

The following are my takeaways from observing multiple meetings between investors and entrepreneurs. The Interpersonal dynamics between CEO/board members and between individual board members can be very telling – they provide an indication of how much thought has gone into the strategic leadership of the firm, and whether the group can work well as a team. Note that board dynamics will look very different between startup, private equity, and public companies. This post will focus on startup boards, which are typically made up of investors and some advisers.

A healthy level of tension helps a board and management team think critically about a startup’s direction

Startups are in a constant fight for survival. Startups that are not facing any tension are not thinking critically about the problems that they need to resolve in order to survive. At the other extreme, if there is too much tension the leadership and company becomes dysfunctional resulting in the death of the company.

Thus, it is the leaders’ job to maintain a healthy level of tension. Boards must be able to have honest, objective discussions about the strategic direction and decisions a company will make, and the leader of the board (the CEO and/or the Chairman) is responsible for facilitating this discussion. This is accomplished in a few ways:

Agenda Setting: Leadership teams have many important things to worry about day-to-day to execute on a strategy, and a limited amount of time should be spent in high-level strategic meetings. Prioritization of important topics of discussion is key. Deciding what to discuss and what not to discuss should be the result of careful deliberation, and not left to open-ended discussion.

Socialization: Board meetings should not be the only time that a leadership team communicates with its board members. Important news should be spread ahead of time such that an appropriate discussion can be had. If you wait until a meeting to drop a bomb, board members will not have had the opportunity to do their homework. The resulting discussion will be much lower level and informative rather than deliberative.

Selecting the Right Team: Because a variety of skills are needed to build a company, leadership teams and boards should be made up of people who bring different perspectives to the table. However, it’s going to be difficult to get mileage out of a board if they don’t understand the business and industry dynamics. Entrepreneurs should do substantial diligence on a potential investor by asking other entrepreneurs that they’ve invested in about the investor’s knowledge of the industry, accessibility, and overall ability to add value.From a people perspective, boards should have members that provide dissenting opinions. This doesn’t mean that every board meeting needs to be a bitter argument, but a board filled with “yes-men” provides no value either. A good investor on a board acts as both a coach that provides critical feedback and as a support team to provide the leadership team with resources it needs to succeed.

At the end of the day, a board’s purpose is to serve the company – they have a fiduciary responsibility to the shareholders of the firm including common shareholders and employees. If you are the CEO, it’s up to you to design your board and board meetings to maximize the value you get from it.

The relationship between the investor and entrepreneur is what you make of it

There are two extremes that an investor-entrepreneur relationship can look like:

Investor disengagement: Investor might not even show up for board meetings, or shows up to meetings and gives weak advice. The investor is not invested emotionally in the success of the entrepreneur or the business.
Investor partnership: Investor is deeply engaged in the business, and is at the company multiple times a month. The investor and entrepreneur can both see that the other party wants what is best for the business, and a partnership is built based on trust.

A good investor is plugged into the business and actively engaged in coaching the management team and offering advice. This investor engagement can be extremely valuable if the relationship develops into a true partnership and can help align the incentives of the investor and entrepreneur. On the other hand, the development of personal relationships between investor and entrepreneur can complicate the relationship dramatically, making it more difficult to give honest, objective feedback. It is up to both the investor and entrepreneur to optimize for what is best for the business, and to build their relationship thoughtfully. If an entrepreneur doesn’t put effort into choosing an investor who they can partner with and doesn’t work to build that partnership, the default is to have a useless investor relationship.

Entrepreneurs must manage a fine line between confidence and arrogance

Aaron Harris of YC recently published a great blog post on I and we. While the discussion is focused on the relationship between an entrepreneur and their employees, but this discussion of ego is also applicable to the investor-entrepreneur relationship. Generally speaking, the investor is not in the trenches in the portfolio company’s industry. As a result, the entrepreneur has more detail and information from the day-to-day operations than the investor, and thus has a higher knowledge base for making decisions. On the other hand, it’s harder for the entrepreneur to evaluate firm strategy objectively due to their involvement in the day-to-day running of the firm, and because of human factors that cloud the passing of information.

Assuming the entrepreneur and investor have a good relationship (which is not always the case), an entrepreneur must manage their ego to effectively leverage their investor. This does not mean that the entrepreneur should blindly follow every single piece of advice given by the investor. Rather, they should remain objective by communicating the rationale of their decisions based on data. The entrepreneur should remain open to reevaluating their decisions based on new pieces of data that investors may bring to the table.

While the entrepreneur-investor relationship can be very complex due to the boards’ role in deciding to support or replace the management team of a firm, I believe that investors can add value to portfolio companies. Much of this value can be captured only through thoughtful building and maintenance of the board. Although many leaders strive to make decisions based on thoughtful data analysis, the reality is that effective decision making and leadership require effective management of people. Investors and entrepreneurs alike would be wise to think just as carefully about personal dynamics as they think about the business situation itself.

What I Learned About Venture Capital This Summer

September 8, 2015September 2, 2015 / Nathan Guo / 1 Comment

I’ve worked with Lux Capital over the last six months as both a part-time and summer associate. I’m writing this blog post to reflect on some of the lessons I’ve learned. In this post, I plan on covering a number of topics including how to add value to a venture capital firm firm, what VCs do day-to-day, how to evaluate whether you’re a good fit, and how to think about getting a job in venture.

How To Add Value To A Venture Capital Firm

Constraints such as industry and investment stage focuses can have a big impact on which activities add value, and venture capital firms pursue different mixes of these activities to benefit their stakeholders. Here are the primary ways to add value to a venture capital firm:

Sourcing – Sourcing looks very different depending on the firm. Some firms have big brand names that attract so much inbound startup interest that they spend more time filtering than they do hitting the pavement to find startups. Sourcing channels look very different across industries as well. For example, although it’s possible to find cool consumer software startups on Product Hunt, biotech breakthroughs might be found only through people connected to academic systems or university tech transfer offices.

Sourcing is finding reasons to say yes to investing in a startup. Questions one might ask include:
- Are the founders the right people to build the product?
- Is the market opportunity big enough for a venture return (in the billions not millions)?
- Is there product-market fit?

Due Diligence – Due diligence looks very different from firm to firm, and many firms rely heavily on the lead investor to take on the brunt of the due diligence with the assumption that they will do sufficient diligence, given that they are taking the largest risk.

Diligence is finding reasons to say no to investing in a startup. Questions one might ask include:
- Are the founders ethical?
- Does the startup have a moat/competitive advantage?
- Is the startup missing key people that they will need to successfully execute?

Portfolio Company Support – VC activities that may add value to a portfolio company include providing introductions to relevant people, helping find and introduce key hires and providing a sounding board for key business decisions. Entrepreneurs should do just as much (if not more) diligence on their investors. Speak with other startups backed by investors to understand whether potential investors are good board members and value adding.

Investor Relations – AKA fundraising. Most venture capital firms are in a perpetual state of fundraising whereby they are deploying capital from the last fund at the same time that they are raising money for the next fund. Some funds attached to other entities (think corporate VCs, large asset managers, etc.) don’t have to bother with fundraising, although they may dedicate extra time pitching to investment committees or integrating portfolio companies into the corporate side of the business.

Other (Portfolio Strategy, Attending Conferences, Operations, Marketing, etc.) – Given the dynamic nature of venture capital firms, there are a number of important activities outside of those previously listed. These vary in relevance depending on a firm’s size and investment focus, so your experience may vary.

What Do Venture Capitalists Actually Do? Are You a Good Fit for Venture Capital?

Beyond professional competencies there are a few functional traits that are common to VCs:

Hustle – Do you have the ability to work with little to no direction, or do you need structured problems and projects to succeed? This is a key difference between venture capital and traditional MBA paths like consulting/investment banking, where there are clear projects and workstreams. Hustle is NOT the same as working long hours – it’s the spark and drive to get things done without someone else telling you to do so. My own hustle has ranged from academic to professional: I took organic chemistry at age 17 at an accelerated high school program and ended up graduating early from UT Austin. I played poker professionally to pay for school and help support my family financially in the early days of my career. I chose to do an internship this summer before starting my full-time job while many MBAs were on vacation.

While there is certainly mentorship and apprenticeship, venture capital firms are not structured like consulting firms and investment banks with in-depth, structured training programs. Thus, you must be a self-starter if you hope to succeed in venture. Even more important, all the entrepreneurs you are funding have insane amounts of hustle. If you can’t hustle as much as your entrepreneurs do, you aren’t the right investor for them. While it is important to be 80/20 while sourcing, you’d better hustle and learn as much as possible during diligence and after investing if you want even a chance of being able to add value to your portfolio companies.
Ability to manage cognitive dissonance of cynicism and optimism – A somewhat cliché quote from F. Scott Fitzgerald states, “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

Let me be the first to say that this quote is somewhat narcissistic. That being said, VCs face a very difficult problem: New businesses that will eat the world 10 years but don’t exist yet look absurd today. Absurd businesses also look absurd today. Successful venture outcomes rely on fundamental changes in human behavior that are rooted in Extremistan. Black swans are impossible to predict, because the data we have today do not show the scale of the coming change. Most VCs address this problem by talking to people. Constantly. They try to find both confirming and disconfirming data and opinions. Decisions for truly revolutionary products will by definition always have more disconfirming than confirming data.
Intellectual Curiosity/Passion – VCs are passionate about not only what a product is today, but what the business will be a decade from now. It’s going to be near impossible to find and evaluate startups if you’re not passionate about new products. If you’ve never beta tested a product in your life, it will be very difficult for you to understand an early stage startup’s customer base.

In addition, VCs love learning, and that learning converts into both sourcing interesting startups and connecting with people that help develop frameworks to evaluate whether a startup is a good investment. Do you enjoy talking to other people about their work, even if their work is not something you’d like to do yourself? I am extremely curious in people, and one of my core life assumptions is that everyone has different life experiences and unique points of view that I can learn from. If you ever see me on an airplane, I’m likely talking to the stranger next to me. Although I can be introverted and need alone time to recharge, I feel extremely excited about the prospect of a day of back-to-back one-on-one meetings with interesting, passionate people.
80/20 – VCs see lots of deals. Tons of deals. Because of the time constraints of having 24 hours in a day, VCs have to say no to deals all the time. Sometimes, they say no to great deals. VCs are constantly trying to filter between signal and noise, and they need to be able to get to 80% of the “truth” quickly to decide whether they should continue to invest time in a startup or an idea. Often, the “truth” you find leads you to say no quickly. Sometimes, you find something interesting and continue digging. Rarely, that digging leads to an investment.

80/20 in VC looks very different from 80/20 in private equity or management consulting. Because the markets are totally nascent, the analysis is much more qualitative than quantitative. Consulting cases generally dig into every last branch of a framework through multiple workstreams. VC diligences hit on the high level branches and dig into only a few of the branches that they deem interesting. That’s not to say that they don’t go deep at all, but they are not exhaustive diligences that last weeks or months. One big reason for this is that you can do too much diligence.

Certainly one important question anyone interested in VC should ask themselves is: “Do you believe in venture capital as an asset class?” If you’ve never thought about this question before, you should read this Kauffman report.

Paths Into VC

There are a few ways people tend to get into VC, including:

Entrepreneur – Or other operational roles in early stage firms generally with a fairly successful exit and good relationships with VC backers
Journalist – Usually covering entrepreneurship and technology
Finance – Asset management with exposure to early stage private equity/venture capital, or consulting/investment banking in relevant industries, such as tech or healthcare)
Networking – Few venture firms post job openings like traditional companies. Many hires are people that are previously known through networks

Many who get into venture have a stellar academic track record, and most have some background in technology, investing, or both. That being said, there are no reliable pathways into VC. Like most opportunities in life, opportunities in VC come from some combination of luck, timing, and surface area for opportunities (read: network). If you’re coming from one of the aforementioned paths, you’re still going to have to hustle to get in the door.

Ask the questions that nobody else asks because they assume the answer is no. Add value before you’ve even asked for a job. Don’t take no from an answer, and find out what it will take to convert a no to a yes. The hustle and preparation for getting a VC internship parallels what actually being in the job is like: VCs are very busy people with a substantial amount of inbound interest. Great entrepreneurs are extremely busy building their businesses and have tons of inbound interest from customers, partners, potential employees, and investors. Knowing how to get someone’s attention who has high demands on their time is an important skill to have, whether you’re trying to get into VC, or just trying to accomplish something great.