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Why Venture Capitalists Dominate New Markets


Why Venture Capitalists Dominate New Markets

The success of the Venture Capital (VC) industry is staggering. Despite financing just 1/6 of 1% of the new businesses in the United States, VCs back a full 60% of the companies that grow to the point of an Initial Public Offering (IPO). Year after year, VC returns exceed public market comparables – one study found that the average VC fund has outperformed publicly-traded stocks by 25%. Especially for new markets, the VC model is tremendous.

Why? We can boil the distinctness of the VC approach down to four major elements:

1. Blank Slate Strategy

Most large companies devote substantial resources to strategic planning, so it may seem odd to say that VCs succeed in part due to strategic clarity. The distinction is that corporate planning is typically focused on maximizing the potential of an existing business, and so it sees the world from the perspective of a company seeking to push more units of whatever the firm sells. The plan revolves around variables such as how much to invest in marketing and R&D and how aggressively to price. Frequently, the strategic plan is really a financial plan with a thin veneer of competitive analysis on top. There is little fresh thinking about industry change, nor about how an entrepreneur would approach the industry if he had a blank slate. As Clayton Christensen has chronicled very well, this is how companies end up in strategic dead-ends – Digital Equipment kept on making better and better mini-computers, but owners of PCs simply did not care.

A VC uses a totally different lens. He is constantly scanning the world for new markets that seem on the cusp of taking off. He develops a clear point of view about how these markets might evolve and what sort of bets might work out. Then, sometimes, he waits. As explained by David Aronoff of the leading early-stage investor Flybridge Ventures,

“We take the crocodile approach. We identify trends that we have a passion for, we find out enough about them, and then we lie in the relevant pools waiting for interesting things to float by, from entrepreneurs, academia or companies that have been bootstrapped.”

Other VCs will seek to run a strategic play again and again. Versant Ventures, a major healthcare VC firm, invests across a wide array of medical specialties and technologies. However it looks for some common features in its portfolio companies. As explained by Versant’s Charles Warden,

“We like to move the site of care, from an expensive and centralized setting to one that is more cost-effective and accessible. We also like to support less invasive technologies. These might sell at higher prices than more invasive alternatives, but the faster patient recovery time reduces the total cost of care. We also try to be first to market with a strong intellectual property position and an ability to generate more data about medical outcomes than any competitor. Sometimes we will follow if a technology is clearly superior to current options. We avoid the middle ground, where there are multiple players in a nascent market and we are trying to pick which technology will win.”

VCs succeed because they are strategic opportunists. They follow a strategy suited to the moment, not to yesteryear when an established company first entered a market. They focus resources on what has high growth potential today, not on sustaining businesses that may have already passed their peak. Because the canvas for VCs is so broad and open, they have to be very clear about what they are seeking. When the opportunity presents itself, the crocodile can then move lightening fast.

2. Portfolio Planning

Consider your retirement plan. It likely has a mix of assets – stocks and bonds, domestic and foreign holdings, and perhaps precious metals and real estate. In some years, conservative investments will do well. Other times are more favorable to riskier assets. While any particular holding might have a great or terrible year, over time total performance balances out.

Now consider the typical company’s portfolio of investments in new markets, when these investments exist. There may be a very small handful of ventures – not nearly enough to provide year-to-year stability. Because sallying into new markets is so distinct from most companies’ norms, approval for these investments may come all the way from Mount Olympus. The Gods in their plush offices decreed that they liked an idea. The C-suite does not deal in small figures, so plenty of money supports the few ventures approved. Failure would therefore be crushingly expensive – financially and for a few peoples’ careers – so the venture may play “small ball” – going for easy wins that may not be market-shaping moves. Or, if the going gets really bleak, the venture may try to double-down on its wagers by investing in a massive push to snatch victory from the jaws of defeat. Either way, many of the investments fail to meet expectations. They sputter forward, or they flame out.

In other words, the corporate portfolio lacks asset diversity. It owns a few Treasury bills and a cement factory in Uzbekistan. This is not really what the Gods wanted, but their lack of a portfolio plan allowed the peculiar calculus of company politics to create a mix of holdings that no right-minded investment advisor would dream of recommending.

A VC looks at the world in a completely different way. He knows that 6 out of 10 VC investments will be a total loss. Another 2 or 3 will pay back the investment but make little positive return. Hopefully, the remaining 1 or 2 will be huge wins. He can make this formula work by rigorously limiting amounts invested until companies prove their potential, spreading his wagers over several investment theses and ensuring that the inevitable failures are quick and inexpensive. He looks askance at portfolios where every investment works out. As the autoracing great Mario Andretti once said, “If everything seems under control, you’re just not going fast enough.”

A portfolio plan provides courage to kill new ventures. For a large company, this can be terribly hard. Ending a venture sometimes means effectively terminating a career, so the natural tendency in most big firms is to struggle forward. With a portfolio plan, it is easier to kill 2 out of 5 investments if the plan allows for only 3 to move forward. The plan provides cover for people associated with the losing ventures, allowing them to save face by blaming the strictness of the process; it can make the career stakes less life-and-death.

Additionally, the plan allows for better budgeting of resources. Many new market programs start with backing multiple ideas. As the concepts grow to become real businesses, the needs increase for money and skilled staff. New projects also keep coming in; there is often no shortage of interesting ideas or their champions, and it is hard to deny support to potential internal allies of the new market program. So the firm tries to stretch its resources, leading to longer timelines for building the ventures. Ultimately the situation reaches a breaking point and many projects are cut all at once. Critical decisions get made very quickly about what stays and goes. A VC avoids this trap by knowing at the outset how many financial and human resources will likely be required at what time. He does not spread his resources too thinly, and he can provide appropriate support to ventures as they grow.

Few companies are more rigorous than Royal Dutch Shell. In a business where billions of dollars are invested on the basis of geological probabilities, Shell puts great emphasis on detailed analysis and minimizing its number of failed explorations. Yet in its Gamechanger program, which emulates VC practices, the company has a totally different approach. Gamechanger aims for 3-5 big wins per year. To get there, the program estimates it needs at least 200 ideas, with 50 active projects at any one time, of which 15% get to proof of concept. In some years just 35% of those are deployed. By expecting such a high rate of failure, Shell can pay appropriate attention to sourcing the requisite number of ideas while preserving resources for its most promising ventures.

3. Expectation Of Variabiity

For a well-established business, spreadsheets rule. The potential profitability of investments determines where the money flows. Because the company understands its business deeply, it can require managers to submit detailed budgets for coming years and hold them to their word.

New markets should be treated differently, but oftentimes they are not. When I was building a mobile commerce business in Africa, a very senior executive at our corporate parent – one of the continent’s largest cellphone networks – closely examined the two-year budget I had just passed to him. He leaned over his desk, looked me keenly in the eye, and said, “This is a contract. Do you understand?” Unfortunately I did, and I was terrified. We had just set up our systems, had no customers, and did not even have regulatory approval to operate. The revenue figures were a total guess. I had a rough idea of the total market size, but huge uncertainty about how quickly customers would sign on. One might think that a totally new industry in a place like Zambia would be given some leeway to find its path, but no. The company’s budgeting process needed my figures to create an overall revenue estimate for non-core businesses. The consequence was that my wild speculations were placed on an equal footing with rock-solid estimates from well-known holdings that the company had owned for years.

Now listen to how a VC approaches this task. David Aronoff at Flybridge Ventures explains,

“The VC approach to financials for new start-ups has nothing to do with what I learned in business school. I want to ensure that expected expenses are reasonable, and we do some sensitivity analysis around that. This tells us how much money we need to raise. We look at the business plan’s revenue picture, and then we throw it out the window. This is at best a dream.”

The VC method reflects how an asset manager would evaluate high-risk holdings. He has a plan for how much will be allocated to these assets every year, and a targeted rate of return on those investments. However he knows that any one investment will likely deviate significantly from that target. The secret is to have enough investments so that the variability is neutralized.

Because a VC does not budget based on fictional revenues but instead focuses on real costs, he does not over-fund ventures. He asks how much is needed to finance the company until its next funding round, which is typically associated with a major milestone in the firm’s development such as its first customer. This approach concentrates the company on that milestone, avoiding distraction from the countless other things that the company will eventually need to do but matter little in terms of reaching that immediate goal. The VC thereby keeps his investments manageably small, which enables him to spread his bets.

4. Sequencing Risks

The VC not only sets focused goals for reaching the next milestone but also ties those criteria to the most important risks facing the venture. He is not looking to build an institution for the ages – there will be time later for that. At the moment, he wants to know that the institution is worth building.

For instance, if a company is trying to sell something online the VC may not look for the firm to build a sophisticated IT and order fulfillment system. In the near-term that can be borrowed from another company, or some manual processing can handle the few sales the venture will chalk up in its early days. While the company will eventually need such a system, there is little doubt that it can be created. A much bigger risk is whether customers actually want to buy whatever the company is selling.

For all their sometimes cumbersome bureaucracy, established firms can lack patience. Even if a company’s senior leadership expects its new market ventures to iterate their way toward success, the managers of those businesses may feel differently. They are frequently high-potential staff in the company on a brief stop-over in the venture to build their credentials. They do not have years to show results. Because they are A-list players seeking an unbroken string of successes in their careers, they push to build the business fast. Oftentimes they will be in another position before the potential flaws in this strategy become apparent, and it will be easy to escape blame. By contrast, a venture fund typically has a ten-year duration, and VCs receive much of their compensation on the back-end of that timeframe as investment returns become clear. They have few political incentives to game the system by tackling too much too soon.

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