Over the years, I’ve become more and more convinced that what sets apart great venture capitalists from the not-so-great ones is investment discipline. By default, most all people who work in venture capital are intellectually brilliant and have strong entrepreneurial backgrounds. As such, if everyone is smart, it makes sense to suggest that brilliance alone isn’t a true competitive advantage. Another competitive advantage is having access to good deals. But at a broad level, a majority of the VC funds in the Bay Area usually have carte blanche to the best deals in the country. But there is one defining characteristic amongst VC firms that is not equally distributed or broadly practiced, and that is Investment Discipline.
Discipline is defined as a system of rules and conduct that one follows, usually to create a positive outcome. Investment discipline is no different except that it pertains to how a person or a firm makes money. In the venture capital industry, investment discipline can be described (at the fund level) as maintaining optimal fund size, investing in a reasonable quantity of companies per fund, investing at certain stage (or stages) of a company’s life cycle, maintaining objectives for portfolio diversification, setting concentration limits, maintaining adequate coverage for team members, avoiding trends and not investing outside of expertise, setting valuation guidelines, setting investment reserve minimums, knowing when to focus on the winners and knowing when to let go of your losers, and finally, having a defined process for how investment decisions are made.
Each of these investment guidelines can make a meaningful impact on a venture capital firm’s ability to produce returns. There are also systemic issues that can have an effect on performance, but these are not worth mentioning because systemic issues affect all firms, not just a select few (i.e. a public stock market crash, etc.).
Some venture capital firms have been known to switch from early-stage investing to growth-stage investing, and later realize they were better at early-stage investing and will switch back. Others might shift from investing domestically to investing internationally. And there are some who may be great technology investors, but decide to switch to investing in healthcare. This sort of erratic investment behavior can be confusing to a venture firm’s investors (limited partners) and can sometimes result in limited partner attrition.
In most walks of life, when things are going well, people are less likely to notice the mistakes they are making and often fail to examine how they could do things better. One of my favorite takeaways from business school is that “success tends to mask strategic errors” especially at the organizational level. Great venture capital firms are those with the conviction to stick to their investment strategy and are careful to not let success lead them down paths that could alter their identity, and more importantly, their investment performance. Cheers -KM