Wednesday, July 30, 2014

What Is A "Good" VC?

People tend to confuse a VC with a good investment record with someone who can actually help startups.  In both cases, these people are called "good VCs", although in the former case they may be quite terrible for a startup to work with.

This confusion was recently re-enforced in a PandoDaily post where a good VC is defined as someone who gets to invest in hot companies.  E.g. "Those companies have their picks of investors. Clearly these non-founder VCs are doing something right."

The ability to convince an entrepreneur to let you invest, or access to invest in a startup, does not mean the VC is actually helpful to the company.  A number of name brand investors are eventually viewed as pretty useless by the entrepreneur once she has had a few board meetings with them.  In some cases, name brand investors can be actively destructive.

The basis for this confusion is that the venture industry is a bundled product.  Right now VCs provide a bundle of capital (investment), advice (helping the startup), and governance (taking a board seat).  The best investors return-wise aren't necessarily the best advisors (although a subset are), and some of the best VCs return-wise act badly from a governance perspective.  People tend to confuse a VC picking a great startup, with the VC being somehow responsible for the company's success.  A number of startups I know have succeeded despite their investors.

The venture capital bundled service includes:

0. Capital/investment.
Some of the very best investors in terms of dollars returned are also really great advisors.  For example, Peter Fenton is known for working hard for his companies, and also has made some pretty spectacular investments.  Reid Hoffman similarly was one of the angels in my first company, and was always incredibly helpful to talk to.  Vinod Khosla is known for pushing the thinking of entrepreneurs.

However, many brand name VCs are actually not super helpful to the startups they invest in.  Rather, they are able to pick the right startups to invest in, and attract entrepreneurs to work with them, despite being poor advisors.  They tend to attract entrepreneurs as follows:
Branding.  This could be through PR, speaking events, blogging, or having chosen great companies in the past to invest in.
Access.  Top tier firms tend to see all the key companies for investment, so even a mediocre person at a great firm can have better access to invest then a great person at a mediocre firm.
Ability to see the future.  Some people are very good at spotting the future and investing in it.  This does not mean they give good advice, however they can be very smart about investing.

These investors tend to have truly outsized returns.  They end up with multiple big hits in their portfolio and make tons of money for themselves and their LPs.  People tend to confuse the ability to pick a good startup with causing its success.  Once a startup has product/market fit and is working, it is often quite hard to derail it.  Some terrible advisors have done really well as investors by betting on startups that largely ignored their advice.

1. Advice (Versus ROI).
Even if you have have the most amazing, helpful comments as an investor, if you are at a lower tier firm you may never have the chance to invest in a break out startup with a dozen funding offers.  Without branding and access it may not matter how smart or helpful you are.  Alternatively, some investors with poor financial returns give great advice to companies, they just tend to pick the wrong companies to give their money and advice to.  Unfortunately, bad company + good advice = bad company.  Similarly, good company + bad advice = good company more often then not (since, as a good company, they either ignore the bad advice, or they have so much traction the bad advice does not derail them).

Reasons great advisors are not always great investors:
Lack of access.  Some thoughtful, helpful people do not have the brand name or access to investment that their less useful brethren may have.  This may be a branding/PR issue, being at a third tier firm, or a lack of prior investment success.

Lack of hustle.  Not pursuing an investment opportunity aggressively.  This can be most impactful if a startup is clearly working and everyone wants to invest in it.

Bad judgement.  One well known investor, and former operator, once told me the secret that transformed him from a terrible investor to a great one.  His view was that he used to look at startups as a strong operator and see all the potential of the idea.  He would get excited about the product area and all the great things it could do.  As an operator, he would imagine how *he* would tackle the market.  This is usually when he made terrible investments.  Instead, he started to ask "what will this specific team and entrepreneur do with the idea".  This allowed him to focus on founder/market fit and improved his return from investments dramatically.

2. Governance/board.
VCs traditionally asked for board seats to both look after their investment, as well as to have a seat at the table to give advice and make decisions (such as choosing the CEO).  As part of their role on the board, investors ultimately are looking out for their own LP interests, but should also optimize for what is globally right for the shareholder base of the whole company.

A lot of the traditional conflicts between investors and entrepreneurs tend to happen at the governance level.  Sometimes it is through self serving advice the VCs give, sometimes it is outright action by the VCs that leads to a poor outcome for the company (e.g. splitting founder cohesion and causing internal battles between founders is one example I have seen).

Some investors can make poor decisions when it comes to broader corporate governance.  They may invite other members of their firm unasked to board meetings to "gang up" on the entrepreneur, or be willing to leak information to the press to endear themselves to bloggers.  As an entrepreneur, once you have taken a VCs capital, you are often stuck with their governance as well.  You should reference check your board members thoroughly.

Is Venture Capital Going To Get Unbundled?
For late stage investing, Yuri Milner effectively unbundled capital (he invested large amounts) and governance (he has not typically taken board seats).  Will a similar set of investors emerge for early stage companies?

So far, early stage investing has only partially unbundled for the following reasons:
a. Early stage companies tend to look for investors who can help.  Entrepreneurs explicitly want investors who can also advise.  Some entrepreneurs are willing to lower their effective price / market cap for helpful investors.  The entrepreneurial market will demand the ongoing bundling of at least some capital and advice.  The alternative would be to raise capital from "dumb money" and then add advisors who earn equity in a company.  However, a fundraising process is time intensive enough that ongoing bundling makes sense for the entrepreneur efficiency-wise.  Why spend a lot of time searching for both capital & advice when you can save time by getting both through one investor?

b. Branding.  Some investors are really great at marketing themselves.  Irrespective of helpfulness, they can still invest in great companies.  This will prevent full capital unbundling.

c. Contrarianism.  Amazing investments are not always obvious and some of the best companies do not always have great funding options early on.  So, great companies may get saddled with poor investors due to a lack of choice early on.  It is only later, when things are very clearly working, that the startup may have more choice on who to work with.  At this point it is hard to remove poorly functioning investor board members.

Related Posts
How To Choose A Board Member
Bad Advice