‘Venture’ On?

After a recent venture investment I made in my personal account took a big hit, I’ve been thinking a lot about the skill set it requires to be successful as a private investor versus that required to be a successful public market investor. Historically, there has been a delineation between venture, PE, and public market investing, but I’ve noticed those lines have become blurred over the last decade or so, with investors getting involved on both sides of the liquidity spectrum. While I am no different, my exposure to venture investing is tiny. Even the investment referenced above was a very small percentage of total net worth. In fact, all my venture investments combined, not including ownership of Farrer Wealth, make up less than 3% of it.

Despite the minor allocation, it always hurts to lose money, and the nature of venture investing is that the result is typically binary; you either get more than what you invested or absolutely nothing back. So, if possible, I’d rather avoid going through this experience again. Thus, to hone my venture investing skills, I thought it would be useful to go through a post-mortem of the transaction. I won’t go into any specifics as the nature of the investment and the ongoing issues are still confidential. Instead, I’ll go through my analysis by talking through the cognitive errors I think I made. I hope you, dear reader, can draw some learnings from my experience, and avoid the same pitfalls. 

Learning #1: Success in one arena does not equate to success in another

One of the reasons I invest so little in venture is because I don’t think I have the skill set for it. Some of the key features that make me a decent public markets investor such as the ability to stomach volatility, patience, and the courage to reach for ‘falling knives’ are not really applicable to venture investing. However, in this case, I fought my hesitance as I had significant amounts of experience in the industry I was investing in. I had made a few successful investments in same industry via listed stocks, and I thought due to my knowledge of said industry I had ‘de-risked’ the venture aspect of the investment. Clearly, this proved not to be the case. I was right in the sense that both public and private companies in the space are having tremendous success, but I was wrong in my specific choice.

Learning #2: Riding Trends instead of the business

When doing my diligence for this investment, I spent time with the management of the company. There were some leaders I was quite impressed while I had serious doubts on some others. Further, I didn’t quite agree with some of the strategies of the company. Having seen how competition had played out in the listed space, I had a reasonable sense of what it would take to win in the regional market I was investing in. Thus, when management gave me the sense that they would go in a different direction, I should have taken a step back. However, I felt the trend of the industry would raise all boats, and even if my investee company had been in the top 5 players, I would have made a solid return on my investment. This was a poor assumption, and this thread points out why. Betting on trends is usually a recipe for disaster. Warren Buffett often uses the auto industry as an example for this, at one point in time there were 2,000 auto start-ups betting on the market, almost all failed miserably, even though the auto industry as a whole did phenomenally well. I have lived this example all too well now.

Learning #3: Picking the best of what’s available

I think access to strong deal-flow is the number one attribute that separates private and public market investors. As a public market investor, I have the same deal flow as the investing legends we discuss regularly. However, in venture (and private equity), deal flow is everything. I often think about the quality of a venture deal if it’s reached my desk. While I have some reputation as an investor in the local community, it's certainly not for venture investing. So, for a deal to have come to me, it would have had to be passed on by every top VC, every 2nd tier VC, every 3rd tier VC, every top family office, and every famous individual VC investor. Will I find a diamond in the rough if I invest in 100 deals? Probably, but I will likely have a huge failure rate, simply because the quality of the deals coming to me is poor. I saw a quote on Twitter once, that I tend to agree with. It said, “If it’s easy to get into a VC deal, it's probably not worth investing in.”

Now granted, this wasn’t the exact case in this deal, as there were top bankers running it, and one of the reasons I was asked to invest was because of my knowledge of the industry. However, the key difference here is that in public markets my choice wouldn’t have been limited to this deal, I would have looked at all its competitors and chosen the best of the bunch. In this case, as I didn’t have access to the other deals happening in the industry simultaneously, I couldn’t choose from them. Instead, I had to choose from what was available to me. I doubt a strong VC or VC investor would have had such a problem. This experience reminds me a lot about an essay I read a few years back about how great companies hire. Mediocre companies hire the best of what was available to them (i.e., those who applied for the job), even if the fit is not perfect, whereas great companies wait to find the exact right person for the job, not matter how long it takes to find them.

Just coming back to the power of deal flow for a second, this paper, published by Morgan Stanley, shows why its so important. It turns out that persistence is a real key in venture investing.

Essentially, the data shows that funds that perform in the top quartile are more likely to end up there again in their next fund, as they start to see far better deals. The best funds see the best deals, and because they see the best deals, they end up becoming the best funds. I’ve found that the best VC investors are also incredible networkers, they know every company and everybody worth knowing, so when a hot deal comes up, they are in the thick of it.

Learning #4: Company building

I think this gets overlooked, but when you invest in a private company either in the venture or growth stage, you’re really in the business of company building. It takes a lot of work to get to 0 to 1 and even more work to get from 1 to 100. Therefore, strong start-ups look for investors who can help them grow either through operations, introductions to customers, and helping them out of crises, rather than just give them money. In my recent venture investment failure, this point was brought home. When the company - which had significant momentum - ran into trouble, it didn’t have a cap table strong enough to help bail it out. Public investors on the other hand, really don’t need to do much. They need to track the investment but can be quite passive otherwise. I think this tweet by Altos Ventures’ Ho Nam puts this nicely. Public Investors are deal /stock pickers, whereas good venture investors should be company builders.

I thought I could be a deal picker in a business that requires company builders, and obviously I was wrong, which brings us to the next point.  

Learning 5: Assuming point-point accuracy

Astute readers will already notice this problem with my “strategy” in venture investing. It’s abundantly clear I just don’t do enough of it. While in public markets I can be quite successful making just a handful of investments and sitting on them, I don’t know of any venture fund or investor who follows this strategy. Most will make dozens, if not hundreds, of investments as the failure rate can be quite high. The difference here is that in public markets I can build a position slowly, add to it as it succeeds, or get rid of it in an instant if my thesis is wrong. This is the power of liquidity. I have no such power in private markets and making just a few venture investments and assuming they will go well, is a bit silly.

This is the reason that if I do want exposure to the venture space I tend to do it through funds. However even here one must be very careful, as the data below will show that the dispersion in returns of venture funds is far greater than those of public equity funds. Basically, this implies that while there are VC funds that do extraordinary well, there is an equal amount that perform horrendously.

Learning 6: Optimism

One of the reasons I like hanging out with venture capitalists is because they are an optimistic bunch. If you’re investing in the future and are putting your money on game-changing companies, you just have to have an almost sunny disposition. Great VC investors tend to think less about what could go wrong but rather what could go right, as errors of commission are common, but errors of omission are almost deadly. One of my favourite tweets of all time has to be the below from Logan Bartlett of Redpoint, who passed on both AirBnB and DoorDash early-stage investments in a single email. It really shows the pain in venture investing due to errors of omission.

The necessity of optimism hit home during this recent investment, as when the wheels were coming off the company, several investors rallied together to make counter-offers and do what was possible to keep the company alive (and in fact, they may still be very successful at these attempts). I was impressed by this, especially when I thought the writing was on the wall. It dawned on me that these investors were used to the venture space where failure was a common occurrence, and unlike in public markets where I would have bailed through a few clicks of a button, they were used to sticking to it till the bitter end. This is because they believed in the business and its prospects and were more worried about turning an error of commission into one of omission by not fighting for the life of the company.

Conclusion:

In the end, this investment experience was a painful but necessary learning experience. I also didn’t lose much money in relation to percentage of net worth. That said, I’ll be honest, it would be more fun to have ‘lost’ that money travelling or at fine restaurants. Also, no client money was lost, as this was a personal investment. In fact, I make it quite clear to clients I don’t recommend private deals as it’s not my area of expertise… yet. I certainly don’t think I’m done venture investing but I do think I need to re-think my strategies, and hopefully my mistakes here will not be repeated in the future.

Thanks for reading – and as usual, happy investing!