At C-Level

The Foolishness of the Masses

There's an ugly cousin to James Suroweicki's popular theory of The Wisdom of Crowds.  Let's call it The Foolishness of the Masses.  I thought of this today while reading Rebecca Buckman's article Where's the Cash? in Forbes.  (By the way, I think Buckman writes more authoritatively and insightfully about the venture capital business than any journalist I know.)  The article points out that six months ago web entrepreneurs were getting soundly rejected by VC's if their models weren't based on ad revenues. Now that rates have fallen, the pendulum has swung wildly in the other direction.  Venture Capitalists, perhaps more than any other industry, move in herds, often relying more on popular thinking than good sense.  (Which is why, as Buckman has pointed out in other meticulously researched articles, an average investment in a VC fund has historically been much better for the venture capitalist than for the investor.  But that's another story.)

VC's aren't the only ones who suffer from The Foolishness of the Masses.  Almost every company that has ever hired an executive does the same when they issue specs for a resume that fits the traditional and expected background for the job.  When was the last time a CEO said to a recruiter: "Find me the best available athlete.  We can teach her the insurance business.  But we can't teach talent!"  To test the ridiculousness of this mass foolishness, ask any CEO if he or she would likely be successful running a business very different kind of business.  Most will confidently reply in the affirmative, stating that they would leverage the same capabilities and principles that have made them successful in the past.  So why doesn't the same principle apply to new hires?  Simple: The Foolishness of the Masses.  Everyone recruits the same way, so it must be the thing to do.

I"m reminded of something Mark Twain once said: "Whenever you find yourself on the side of the majority, it is time to pause and reflect."

Venture Capital and the Economy

After today's double-digit market gains, everyone is hopeful that the economy is on the road to recovery.  However, it is important that we all recognize that this is a very long road.  We're all going to have to rethink how we do business in the near future, and maybe forever. 

Having run a few venture-funded companies, I started thinking about how the economy would impact VC funding, and the answers were not intuitively obvious.  So I asked a few VC friends from around the country how the economy shift was going to affect their investment strategy.  Their answers were interesting:

Jordan Clements, Peterson Partners, Salt Lake City

As a hybrid investor (cross between late stage VC and private equity) about two-thirds of our investments include an element of debt financing.  For example, if we buy a company for a 5x multiple of EBITDA, we might fund that with 2x equity, 2x senior debt and 1x seller financing or mezzanine financing.  With senior debt no longer available for the foreseeable future, we’re going to have to be more creative in how we structure buy-outs.

  As to the balance of our investment activities that are in the nature of growth capital investments, no debt financing is involved.  My anticipation is that for the near term, most of our investments will be structured as growth capital investments (all equity), even those that would historically have been structured as a leveraged buy-out.  But that means that we’ll raise the bar for the quality of cash flow and growth potential for any deal that requires all equity.  And our anticipation is that at a future date we’ll be able to use debt to refinance a significant portion of our investment.

Greg Lee, Dominion Ventures, Walnut Creek 

I don’t think it’s going to affect us very much at all.  There’s plenty of money out there already chasing deals, so it’s not going to dry up any time soon.  Now if firms are trying to raise a fund, that will be much more challenging in this environment.   

Alan Veeck, Meacham Becker Venture Capital, Pittsburgh

The current slowdown shouldn’t affect our investment strategy too much.  Since we are a relatively new firm with a first time fund, we have spent the last 2-3 years gradually refining our investment strategy (I call it “tuning the Sniffer”), and we have become significantly more picky about what we invest in as a result.  We have codified several core beliefs about areas in which we AVOID investing (not a strict rule, but directional): 

·         Enterprise Software companies (SaaS, installed, or otherwise) – except in a couple of exception categories of enterprise spend.

·         Hardware companies – anyone making a hard product; it always takes more (2-4X) money and time than founders tell you.

·         Ad-Supported Revenue companies – unless the idea is out-of-the-ballpark, these will almost always remain small companies without more legitimate revenue streams.

·         Biotech/Life Science companies – these are “binary bets” (i.e., they either work or they don’t; no middle ground) and take wheelbarrows full of cash.

Some people might ask, “After those exclusions, is anything left?” – fair play to ya’.  The answer is YES; but not many.  For a small first time fund like ours that focuses on early stage investment, our core belief is that the above types of businesses will have a difficult time gaining significant traction in both good times and poor – so we will continue to refine our investment strategy, but without any big changes.

Interesting perspectives from all three.  It's long been true that in a down economy college enrollment goes up.  Jobs are scarce, so the relative returns of education looks better.  The same might be said for a start-up, assuming you have a VC deal vs. debt financing.