Trident Capital Blog

Lessons from the Past Ten Years (Part 2)

Last week I started writing about the lessons I’ve learned being a VC during the past 10 years.  In the initial post I covered the lessons about training how to become a good investor.  Today I write about lessons relating to investing in private, primarily early stage, companies.

1. Treat your LPs' money like your own. Only then you will be able to approach potential investment opportunities with the right attitude.  And think that the pensions of thousands of people or the running of a university or an endowment (all of which are typical LPs to venture funds) depend on your ability to create superior returns from your investments of the money these LPs provide to your firm.
2. Be patient when approaching new investment opportunities.  I remember that as soon as I became a VC I wanted to make an investment.  I now see the same urgency in less experienced partners joining our profession.  At that time almost every new business plan I would receive looked like a superb investment opportunity.  During my early investment attempts, it took several interactions with my then partners to understand the benefit of being patient and properly analyzing each opportunity.  These interactions helped me avert potentially expensive mistakes and determine each investment’s potential.  Patience implies being thorough and not cutting any corners during the due diligence process (validating and stress-testing each candidate company’s operating model by looking at downside and upside scenarios, analyzing its sales pipeline, talking not only to the references provided by the company but to all other individuals whose comments could prove useful in the investment decision, considering comparable transactions and creating an investment returns analysis), using the results of the due diligence process to create the final set of terms under which I was willing to make the investment, and then patiently negotiating around these terms with the management team.  While it is important to understand that you may be competing with other venture firms for the particular investment, and you need to be respectful of the management team’s time, you also want to progress the negotiations at a pace that allows you to arrive at a win-win conclusion for your firm and the company.
3. Keep your partners informed at every step of the way. The best partnerships are the ones that behave like partnerships.  During the pre-investment due diligence process keep your partners informed of what you are finding, and seek their feedback and advice.  Make sure they are always supportive of the investment opportunity, of how you are handling the investment process, and have all their questions and concerns addressed.  Once you make the investment, keep them informed of the company’s progress, both positive and negative; particularly the problem areas.  Together with your partners you will be always able to decide whether a company is worth your firm’s continued financial and other type of support, determine the right time to exit an investment, e.g., by selling the company, formulate how to help the company with particular customers and partners, and identify which executives to recruit in order to strengthen its management team.  Recognize that your partners are as busy as you are.  So it will be easy to say that I was too busy to update the partnership.  But it is not the right way to go.
4. Make sure you are always on the same page with your co-investors and your management team.  Some times you need to form an investment syndicate and other times you join a syndicate that had already been formed, particularly when you invest in later rounds.  To the extent possible make sure that all syndicate partners have the same vision about the company, its management team, its prospects and its exit opportunities.  For example, if you feel that one or more members of the management team will need to be replaced, have this conversation before you make the investment and agree on a process and timetable.  If you feel that the company’s business model needs to be modified or that the company may require more investment than originally anticipated, make sure that your co-investors agree and, more importantly, have the necessary capital to contribute.  If during the due diligence process you identify particular issues or problems discuss them with your co-investment partners.  Even if you don’t identify mutually acceptable solutions at least you will know where they stand and thus be able to formulate your own approach to each problem.  You need to follow exactly the same process with the company’s management team.  They need to understand your concerns and how to best work with you to address them.  Once you invest you will work with them for several years to come so it is important that you establish the right relationship from the beginning, i.e., before the investment is actually made.
5. Consider the total amount that needs to be invested over the life of the investment. It is not unreasonable particularly for an early stage company to go through three or four rounds of funding regardless of how capital efficient model it is employing.  For this reason, it is necessary to consider the company’s total funding needs and not only the amount necessary for the round you are investing.  Key to this analysis is the financial modeling performed during the due diligence process (including the stress-testing of the operating model).  In addition you will need to understand, and almost take for granted, future changes in the business model.  Such changes are often necessary in early stage companies and may cause the modeled capital needs to increase by 20-30%.  This is another important reason for being on the same page with your partners and the members of your investment syndicate.
6. The biggest contributor to a company’s success is its management team.  Market size is important in determining whether to become interested in an investment opportunity.  But, in my opinion, the quality of the company’s management team is even more important.  So, I always try fund strong management teams, or bring together strong teams before funding the company.  I’ve seen, and have even invested in, average management teams that failed to take advantage of great market opportunities or to even understand when a market was not developing as it was expected.  Such teams tend to also be capital inefficient.  Strong management teams always find a way to make the most of the opportunity presented to them, no matter how disadvantageous, e.g., smaller than expected market, weaker product, etc.  For this reason, I have even included terms in term sheets I issued that called for replacing particular members of a management team as a precondition to the investment.  I much rather lose the investment opportunity rather than invest and then lose my money.
7. Think about exit scenarios prior to investing. As an investing partner in a venture firm you are paid for providing superior returns to the capital you invest.  For this reason you need to start thinking how you are going to create these returns as soon as you begin the pre-investment due diligence process.  If you determine that the most likely scenario for an exit is through an acquisition, then start considering the likely acquirers, figuring out how you may be able to catalyze such an acquisition, and establishing what it will take for this acquisition to occur.  For example, in computer security investments it is important to know where companies like Symantec and McAfee focus their R&D resources and the areas where they will seek partners.  This is another opportunity your personal and your firm’s networks become important.  Keep in mind that the list of acquirers may not always be obvious (for example, few people would have identified Adobe as a potential acquirer of Omniture, yet Adobe paid a princely sum for the company).

In the next and final post we will talk about lessons relating to managing investments.

Lessons from the Past Ten Years (Part 1)

In a few days I will reach a rather significant milestone: 10 years as a VC.  During my recent vacation, I always find vacations good periods for introspection, I started thinking about the lessons I’ve learned during this period. I entered the field after selling my last company in May 2000.  The intervening years were marked by two recessions, including the recent severe one, and anemic venture returns.  Some of my friends questioned the wisdom of remaining a VC under the conditions we’ve been experiencing, particularly since I had several opportunities to return to an executive operating role.  However, every day I continue to be as excited about working with entrepreneurs and helping them build successful companies as I was the first day I joined Apax Partners, my first venture firm.  I thought about writing my lessons into a series of blog posts in the hope that entrepreneurs will be able to better understand some of the influences that impact pertinent investment decisions.

I have organized these lessons around three areas: training how to become a good investor (covered in today’s post), investing in the right companies, managing the investments in order to make them successful.  I will cover the other two areas in subsequent posts.

1.       It takes awhile to develop a good investment sense.  I will say that it took me at least 6 years before I could feel “sure-footed” about leading investments and being able to convincingly articulate an investment case to my partners. While people talk about venture capital being an industry, I liken it more to an artisan guild.  Very much like an artisan needs to join a guild in order to apprentice with a master craftsman and learn his craft, a novice venture investor needs to apprentice with more experienced investor(s), who of course must be willing to teach their craft.  Unfortunately, you can’t read a book or take a course and become ready to invest.  For this reason it is important to find a venture firm with a strong and experienced partnership which is interested in transferring its craft to a novice investor.  Looking for such a firm first in 2000 and later in 2005 after leaving Apax, I came to realize that not all partnerships, regardless of their investment records, are able or willing to teach their craft. 

2.       Join the strongest firm you can.  The right firm will “launch” you faster because from the beginning you will have access to strong deal flow.  Having strong deal flow from the beginning is important since it takes awhile to develop your own deal flow.  I’ve had that benefit both at Apax and now at Trident.

3.       Being a good executive (including CEO) doesn’t automatically make you a strong investor.  Complementary skills need to be developed.  Executives are very good at running a particular business, understanding and adjusting business models, sales models, etc.  They only focus on one business at a time.  Investors, on the other hand, first must be able to deal with multiple companies (their portfolio) at a time.  In addition, they must be able to model a business in a sufficient enough manner so that they can decide the investment terms they will offer.  These terms must be able to maximize the upside and protect against the downside.  They will also need to be effective in the presence of the terms from prior investment rounds. So, it can get quite complicated. 

4.       It’s about how technology and business model innovation can lead to great returns.  The investors that provide the capital to the venture firms, i.e., the Limited Partners, are not interested in whether a particular technology or business model are superior to others.  They are solely interested in maximizing the returns of their investments in the venture funds with which they work.  So, saying that you invested in companies with revolutionary technologies without showing profitable exits won’t mean anything.

5.       Take your time to learn your craft.  Fight the strong desire to invest from the first day.  Learn as much as possible from your firm’s existing investments before you start making your own investments.  You will find plenty of opportunities for improving the decisions of others, before you start making your own investment mistakes.  For this seek to be exposed to portfolio companies that are successful, as well as to ones that aren’t.

6.       When you are ready to build your own deal flow start by looking at companies in your area of expertise.  In this way, you will be able to establish credibility with entrepreneurs faster and offer them significant value, which they always appreciate.  Moreover, since you understand the area, e.g., software, internet, etc, it is more likely that you will be able to easier understand the issues surrounding the investments.

7.       Develop the right networks because they matter once you’re ready to start investing.  You need to develop three different networks: investors, entrepreneurs and executives.  From the first network you will identify the individuals and firms with whom you will co-invest and who will show and share deals with you.  The entrepreneurs in your network will be the ones that will bring you their ideas and companies to invest in.  Finally, from your network of executives you will staff the management teams of your investments and identify independent board members for your companies.  Even if you have great networks to start with, you must never stop networking.

In the next post we will talk about lessons relating to investments in the right companies.