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08/17/2004

The Perfect VC: Operator or Investor?

Conventional wisdom has long held that the best background for a successful Venture Capitalist is that of a hardened industry “operator”. The reasoning behind this wisdom is that a VC with operating experience should be much better equipped to help portfolio investments deal with the day-to-day challenges of running a start-up and can therefore better help manage an investment to a successful outcome.

Indeed, when you ask someone to give you their impression of what a week in the life of a successful VC must be like, most people paint the picture of grizzled operator, sleeves rolled up, dispensing pearls of managerial wisdom as they make the rounds of their investments. Relying on their vast operating experience, these VC supermen are able to take fragile start-ups and through shear managerial brilliance mold them into the Ciscos, Ebays and Goggles of tomorrow.

This caricature, while flattering to VCs, is deeply flawed for two main reasons: First, as almost every VC will tell you, picking the right investment is much more important than correctly managing an investment. Second, generally speaking, the more involved a VC is in a company’s daily operations, the more screwed up the company is.

Nature vs. Nuture
In terms of the first flaw, when you catch most VCs in a moment of honest reflection they will tell you that while they enjoy working with their investments and trying to “add value” by using their operating experience, the single most important action that they take is deciding whether or not to invest. This is because a start-up’s initial “genetics” in terms of market opportunity, technology and founding team are typically the biggest determinants of investment’s success. Put another way, it’s almost impossible to turn a start-up with bad genetics into a good investment, no matter how good an operator you are. Thus, if the initial investment decision is so critical, than it stands to reason that investment skills are potentially more important to VC success than operating skills.

Doomed Rescue?
The second major flaw in the “operator hero” caricature of VCs is that in most cases whenever a VC is required to provide a company with significant operating assistance, it’s generally a warning sign that the investment is headed in the wrong direction. VCs hire management teams to run companies. If these teams do a good job, there is often little need for VCs to supplement the operating skills of the existing management team with their own. However, if the existing management team performs poorly, VCs often find themselves spending an inordinate amount of time at those companies. For “operator” VCs, these poorly performing companies can present a perversely seductive opportunity to try and “rescue” the deal with some VCs in this situation even becoming temporary CEO’s of such investments. Many Limited Partners, other VCs and outsiders applaud such rescue missions as the highest calling of a VC, but these efforts are usually misguided. Companies that are failing generally have one of two problems: either their initial “genetics” are wrong, in which case no amount of tinkering with the operations will help and the whole focus should be on an exit strategy, or the management team is wrong, in which case the correct response is to quickly hire a new team.

Taken together, these flaws seem to suggest that seasoned operators don’t automatically make the best VCs for not only are investing skills more important than operating skills when it comes to picking the right investment, but the more a VC uses their operating skills, the more likely they are making a mistake by not addressing more fundamental issues.

Recipe for VC Success
All this is not meant to say that operating experience is of no value to becoming a successful VC, indeed many of the world’s most successful VCs have highly distinguished operating backgrounds. However it is meant to suggest that the recipe for VC investment success may be a bit more complicated than conventional wisdom might suggest.

At a high level, it would appear that VC’s must be good at a number of things including:

1. Gaining market “perspective”: VCs must be able recognize and understand investment opportunities “ahead of the curve”. This not only requires domain knowledge (either as a result of experience or education) but also some kind of vision for the future of a given industry. That doesn’t mean that VCs need to be clairvoyant, but that they need to be able to place new ideas into a forward-looking context founded on domain knowledge.

2. Investing: Being a good investor takes training and experience, just like any other skill. Investors not only need to understand how to legally and financially structure investments, but more importantly they must learn how to evaluate multiple investments within a consistent and disciplined framework. Risks, rewards, and opportunity costs must all be considered in a disciplined and dispassionate manner.

3. Judging People: Evaluating the character and experience of the managers and founders of a potential investment is critical. As is the ability to detect when changes need to be made in the management team. To this end, VCs not only need to be experienced in judging management performance but also need experience with hiring and firing people as these will be the single most important decisions that they help make.

4. Generating Deal Flow: VCs must be able to generate quality deal flow and must have a strategy for building deal flow over time. Some VCs develop deal flow by employing a classic networking strategy while others hunt for deals in specific sectors. In either case, VCs need focus on generating deal flow or they run the risk of being adversely selected.

5. Avoiding and Spotting Trouble: VCs can use their experience to help their investments avoid common pitfalls and deal with classic start-up issues such as organizational “break points” and founder turmoil. More importantly, VCs should have a finely tuned “spidey sense” that can identify potential problems within an organization before they become a major issue.

While it’s clear that operating experience can help significantly in many of these areas, especially when it comes to HR issues and spotting trouble within an organization, it’s also clear that there are other skills which either aren’t necessarily unique to operators (such as judging people) or aren’t even typically developed by operators (such as investing or deal flow generation). In fact, it’s apparent that a wide range of experiences might make someone a good VC, everything from journalist, to consultant, to investor, to operator.

All this said, there’s a saying in the VC industry (which is periodically adjusted for inflation) that “it takes $30 Million to train a new VC”. The implication is that all new VCs, no matter what their backgrounds, will more than likely make a number of costly mistakes on their first few deals. Viewed from this perspective, it really doesn’t matter what background a VC has, as nothing really substitutes for on-the-job training.

August 17, 2004 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.