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September 15, 2011

Can a venture capitalist add value beyond money?

This is a question I ask myself every day. “Am I REALLY helping my portfolio companies?” And if I am spending lots of time with my companies, does this necessarily translate into better returns for my Limited Partners? This is pretty biblical stuff if you are an investor, and strongly informs both the way you interact with portfolio companies as well as the shape of your portfolio. If I view venture investing as an exercise in asset allocation, e.g., if I assume I can’t add real value beyond my dollar investment, and therefore focus 100% of my efforts on investment selection and portfolio diversification, this would create one type of portfolio. Conversely, if I view myself as being able to have a material positive effect on my portfolio companies, then I’m less concerned with diversification and more focused on creating opportunities to build concentrated positions in companies with high expected returns. Either can be a rewarding path, but I think it is really important to know who you are, the covenant you establish with entrepreneurs and the implicit risks and rewards of your decision. Such decisions even impact the optimal staffing level for a venture firm. Let me tell you, balancing firm structure, philosophy and reputation isn’t easy.

In order to pull off the pure asset allocation play, a few things need to be working:

  • Your firm has huge brand cache that generates awesome proprietary deal flow, where
  • Deal flow is a function of (1) having superstar investors who are power-nodes and (2) outstanding historical performance, which indicates that
  • Both the firm and the partners have built reputations over many years of being in the venture business and proven that they’ve go the goods.

In short, as a general rule I’d say that this points towards long-established, top-heavy firms that scale well because each investment isn’t especially time consuming. Further, it would indicate a larger portfolio as it is harder to ascertain which investments are likely to be big winners due to the gap in engagement between the firm and the start-up, rendering it important to have a broad array of potential big winners in the book. From where these big winners emerge, who knows. But does it really matter? If the curated deal flow is top-notch, it is likely that attractive returns will follow. But precious few firms to my knowledge could successfully pull off such a strategy, as the competition for the best deals gives currency to factors such as hustling, spending lots of time with founders and being deeply engaged with their growth plans. And as the environment for seed stage technology investing heats up, even greater weight is likely to be placed these factors by entrepreneurs.

Consider the firm that believes it can add value to its portfolio companies. Each investment is far more time consuming than the pure asset allocator. It’s not that such firms don’t asset allocate, but additional emphasis is placed on things such as reserve planning and aggressively positioning for the follow on rounds. There is still tough competition for these investments, but a package of money, industry knowledge and engagement plays pretty well to the kind of entrepreneur that wants mentoring and input. Some founders could care less, and in fact actively discourage investor involvement. Then one of the asset allocators described above would be a perfect fit. However, for those on their first start-up or who have had positive experiences with venture investors in previous start-ups, then a more active and engaged venture firm is a better fit. But this kind of investing doesn’t scale as well, as each investor can only work with a relatively small number of companies in order to give each the necessary attention. Also, given the intention and the financial payoff of “going deep” into those companies substantially de-risked through the founder/investor partnership, these portfolios are likely to be far more concentrated than the asset allocators. Fewer portfolio constituents, greater percentage ownership over time. But hopefully the greater amount of engagement and assistance results in better outcomes for founders, LPs and GPs alike.

So while I don’t have an answer to the question that catalyzed these thoughts, I do have a hypothesis: that smart, caring and engaged venture investors can positively impact investment outcomes, but only if the founders want this kind of an investor. Otherwise, the mismatch will cause tension and dissent at the Board level, and potentially throughout the company. This is why having an open and honest dialogue between investors and founders as to expectations prior to investment is absolutely critical, as the best of intentions can go up in smoke when put into practice. It’s an tried and true strategy: know who you are, be transparent as to your expectations and objectives, act with integrity and good things will follow. It’s not rocket science.

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