Picking Winners is Hard

I was in the middle of reviewing some of our VC investment managers and I started to think about the difficulty VC managers have in finding and selecting good companies to invest in. Having worked with individual companies before, I can attest it is an extremely difficult task.

Entrepreneurs have tough jobs too. For first-time entrepreneurs, starting a new company can be like driving a car in the dark with no map, one dim headlight, and very few people know who to ask for directions. This is one of the primary reasons why talented entrepreneurs seek out the best VC managers to partner with. Combining a talented entrepreneur with an experienced VC manager doesn’t always guarantee the company will be successful, but it certainly increases the probability of a desirable outcome.

VC managers often have a high degree of background experience in their respective professions and you’ll see this manifest itself in the type of companies they invest in. If VCs have experience in life sciences, they’re likely to invest in life science companies (and so on…). Even still, VCs face the same challenge of knowing early on which companies will succeed and which ones won’t. Uncertainty Risk exists in every investment (regardless of stage) and good VCs do their best to help companies manage their way through it.

What many people don’t know is larger VCs are investing in several different companies across many separate funds, all at the same time. Granted, they do have staff to assist with this process, but the decision to invest ultimately resides with the General Partners. It’s a tremendous amount of work. Some of the better VCs have advisors and venture partners on staff who work full-time with their portfolio companies. When you think about it, it makes a ton of sense, right? If a VC is investing, say, $10M into one company, it makes sense to make sure there’s a leader in place to steer the ship. Usually the most important factor that heavily influences whether a company succeeds or fails is the management team. As such, it makes sense in a lot of cases for VCs to have control of who’s in charge.

VCs usually don’t take leadership roles in the companies they invest in simply because it’s not practical from a time perspective. However, they will request a board seat for themselves or someone else on their staff. Holding board seats gives VCs the opportunity to provide critical feedback to its portfolio companies within a structured and orderly manner.

In my role, I monitor a handful VC fund managers and find new managers to invest in. Investing in this manner requires knowing a few levels of information: First, it’s important to understand the process VCs use to find and select new companies. Second, it’s important to understand the mechanics of how VC funds operate. Lastly, it’s important to have a broad understanding of the VC industry in general. In many ways, choosing the right VC manager to invest in is no different from finding a new entrepreneur to invest in because both processes require a great deal of due diligence. However, one of the differences between investing in a fund vs an entrepreneur is when an investment commitment to a VC fund is made, there is a contractual obligation to follow through with the full investment (no matter how good or bad the VC fund is performing). Therefore, there is a heightened level of scrutiny that should be placed on selecting fund managers because once a commitment is made, there is no usually no turning back.

VC fund managers have it a little different. If a VC has a portfolio company who is underperforming, it can decide to continue investing or not. Or, a VC can work with a company to make internal changes and effectively try to “manage away” a company’s problems. Having extensively worked with individual companies in the past, this is NOT easy. This is not something an LP can do after making an investment commitment to a fund.

Upon close examination of VC fund portfolios, I’ve noticed many of them contain companies I’m sure no one has ever heard of. Sure, there is usually always a company or two in the portfolio that is well-known to the public, but most of the time there’s not. Contrary to popular belief, most VC portfolios aren’t teeming with unicorns (i.e. companies valued at $1B or more). The good news is having a portfolio full of unicorns isn’t always necessary to produce decent yields. Often time the “wins” within a VC portfolio aren’t huge, but because there are lots of little “wins,” overtime, it adds up.

Individuals investing in venture usually understand and appreciate the challenges VCs face in finding and developing successful companies. Let’s face it, investing in great companies and producing meaningful returns is certainly an art and a science. In my option, I think it requires great skill to know when to assert one more than the other. Cheers — KM.


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