When do VCs make mistakes?

Lately, entrepreneurs reading the VC press  have been seeing investment announcements that leave their mouths agape.  Press releases featuring giddy investors justifying nosebleed valuations have sent them scrambling to the lucky company’s website to figure out what product, team, and idea could possibly be worth that much.  All this leads them to an overwhelming question: “WHY would anyone want to BUY that, much less finance it?”

Let me tell you, VCs often have the same reaction.  We too ask similar questions adding “WHO would fund this?” trying to understand what our colleagues are thinking, followed by the inevitable “how will they ever make a return?”

VCs’ thinking, in many ways, is more like that of a startup than like that of our larger cousin — private equity, who focus on the hard facts and the math behind the investment.  VCs and startups both live in a world of uncertain, unverified, and mostly missing information.  We project outward confidence and seem to know, with conviction which what waits around the corner.  But, in reality, VCs know that their assumptions about markets, customer needs, and business climate are anchored on the same shaky ground that sprouts the hockey sticks startups project onto their walls.  Aside from platitudes we spout with certainty  (“Mobile is big.  Social is important.  Cloud is the way of the future”, etc.), few things are known to us well enough to warrant our conviction.  Just like the startups we fund, we, ourselves, live in an unpredictable world and often make mistakes.

Venture Capital, despite the colloquial taxonomy, is not just a “cool” branch of finance.  And things we learned in business school:  ratios, comparable analysis, revenue forecasting with Excel, are, for the most part, irrelevant.  VC is as much about art as it is about science, about things that “feel right” and betting on people you can see succeeding.

Since VC is as much about feelings as it is about logic, sometimes, we make bad bets.  When does this happen?  I have a few thoughts…

  • In B2C, …when we don’t understand the consumer.
    Companies that appeal to the 20-something crowd are often created by 20-something founders.  Most VCs are not in their 20s or even in their 30s.  And all the hanging out at the Shake Shack does not compensate.  I was recently told (by a company) that I was not “a Facebook mom raising children” and that this was the reason I didn’t get their value proposition.  I thanked them for their insight and promptly moved on.
    When we are asked to believe that something is cool and that all the cool kids will be using it, the only fallback we have is “traction” — that’s why the term has become so popular.  Traction glosses over our inability to step into the shoes of the target demographic and reduces it to spreadsheet math we understand and love.  No due diligence cycle is long enough to properly survey the masses, so we rely on advice from our children (who sit in front of their iMac’s and worry about private school admissions) or dubious year-old sentiment surveys.
    We step into investments hoping the public will like it.  Sometimes it does.  Often it doesn’t (witness Color).   What’s cool with the kids at SxSW isn’t necessarily cool with the rest.
  • In B2B, …when we aren’t in tune with the corporate ecosystem.
    We go to startup conferences and startup events looking for deals more often than we attend established industry trade shows which focus on the big players and their strategy.  We forget to track our potentially crushing competitors and benevolent acquisition sources.  We forget that to build companies they buy, we need to understand their roadmap, product holes,  and where our companies fit in.  Most of us have never sold anything to anyone, much less to an enterprise-sized business.  We don’t do enough of the boring homework, looking at the present while trying, bleary-eyed, to discern the future.
  • *…when we don’t understand the technology.
    *
    Most VC software investments are rooted in technology.  Successes in this business, no matter how social or consumer-focused still requires technology and its competitive advantage to rule the marketplace.  Facebook, LinkedIn, Dropbox, Google all have tech at their core, even if they are not featuring it on their web site.
    Often, we let things be “over our head” and don’t dig deeply enough into what the company is actually doing.  We should never invest in anything over our head.
  • …when we follow the herd.
    When the action in certain investment sectors heats up, the fear of missing out on the next big thing often gets the better of our rationality.  We see other funds, bigger funds, better funds, make large and seemingly better investments.  Whether these investments are correctly valued, whether the funds making them have more resources and can better tolerate mistakes seems unimportant.  It’s all about the game and the fear of not placing a bet.  We need to make an investment in a “space” because we think someone else validated it.  Smaller funds co-invest with famous ones on the premise that the big guys know what they are doing looking at the “earned media” instead of the financial return.
    This is a recipe for disaster.
So, how can we try to avoid these mistakes?  My three cardinal rules are all derivations of “Know Thyself” from the [Temple of Apollo at Delphi](http://en.wikipedia.org/wiki/Delphi "Delphi"):
1. **Don’t submit to peer pressure. ***(Know thy market)*** **If I see a company doing something that, at first blush, seems stupid, I will walk away.  This is a subjective call and I may miss out on the next AirBnB or the next [iFart](http://ifartmobile.com/ "IFart Mobile"), but I’ll be right more often then wrong.  No matter who the other investors may be, no matter how hot the space — I have to be impressed by cleverness of each:  market approach, product, and team, or no deal.
[![](http://blog.thansys.com/wp-content/uploads/2011/08/know-thyself-300x224.jpg "know-thyself")](http://blog.thansys.com/wp-content/uploads/2011/08/know-thyself.jpg)"Know thyself"
  1. Don’t invest in things you don’t understand. (Know thy product)*
    *
    Even if I have advisors who strongly recommend an investment, unless they and the company can explain to me how the company does what it does, how the market mechanics work (unless I already know them), I don’t think VC is a place to run blind and hope for the best.   This means leaving deals on the table — potentially lucrative deals.  But, I will feel as bad about missing those as I often feel about not hitting the MegaBucks jackpot in Vegas.
  2. Don’t invest in people you don’t like. (Know thy people)
    If I can not imagine working with someone for the next five years, I will not invest in them.  If I find the CEO annoying or the CRO obnoxious, chances are, it will only get worse after the investment.  Why voluntarily join a dysfunctional family?
  3. Make the deal simple.(Know thy deal)
    I don’t believe that pricing a VC round should be a month-long haggle session.  I don’t believe in low-balling a deal knowing that it will get negotiated up.  I don’t believe in overpaying either.  One price, a little wiggle room (up or down based on other concessions), simple, standard term sheet — and that’s that.
I hope to keep on knowing myself and finding some good investments.
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