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June 6, 2005

Searching for VC Investments: Multiple strategic dimensions

Bill Burnham has a post on "Deal Flow Is Dead, Long Live Thesis Driven Investing. He argues that the amount of VC money chasing companies today means that the traditional strategy of relying on deal flow is no longer successful except for the few firms with the very highest reputation or a lock on local markets. He summarizes the old strategy with an analogy:

It’s as if Venture Capitalists were Grizzly Bears: Just stake out a good position in the middle of the best salmon run, watch the fish go by, and occasionally swat the best looking fish out of the air. In this model VCs are cast as true renaissance men, capable of doing a communications equipment deal one day and an alternative energy deal the next. They have no need to be experts in specific industries but instead pass judgment on the quality and pedigree of start-up teams with the belief that their connections and experience can help get any company off the ground.
I agree with his observation that successful VCs will not be able to simply rely on broad deal flow but will have to be more focused, thesis driven, and proactive. However, I think this evolution it not so much a shift from one approach (deal flow) to another (investment thesis) as it is an increase in the amount of work VC's have to do. The discussion actually points at a framework for investment strategy.

Here are some elements of such a framework:

  1. push: low (don't do any work to get good deal flow) to high (invest heavily in marketing, relationships, and pipelines to get great deal flow)

  2. pull: low (only evaluate deals that come in the door) to high (only evaluate deals that you go out and find)

  3. scope: general (e.g. any possible investment, from real estate to nanotech) to specialized (e.g. nanomaterials for construction)

  4. theory vs. data driven: theory driven (decide on the kinds of deals you are looking for before looking) to data driven (decide on the kind of deals you like based on each deal as it comes)

  5. comparison: limited (consider one likely company) to comprehensive (consider all available options related to a potential investment)

Each element is a different dimension of a search strategy. I've listed endpoints of each dimension. There are many intermediate points. For example, you can work hard to set up a great deal flow around a moderately scoped area (e.g. internet). Then take deals that come in, and evaluate each deal. When you see a deal that you like, you then develop a thesis about why you like it, and go out and find more options to compare against. The suggested approach argued in the article is extreme on my 5 dimensions: no push, all pull, very specialized, fully theory driven, and comprehensive comparison.

That certainly represents one point in the strategy space. Reducing effort to obtain good deal-flow is not without its limitations, however. Most importantly, that highly deliberative pull approach can be too slow to find deals in a dynamic competitive environment. While you might find some good companies when you have your thesis ready, some of the best companies that embody that thesis may already have gone to investors with better deal flow. In my Mayfield colleague Allen Morgan's words, such an approach is "a good way to find what would have been great deals if only you had been there in time."

Thus, I think there is room for considerable variation in search strategy based on the assets and capabilties a VC or firm brings to the table. If you can get great deal flow, get it. If you have the time to evaluate a space of options before choosing a deal that looks promising, use that time wisely. And if there are enough good opportunities within narrow space to get the returns you seek, and you have or can obtain the relevant expertise, then specialize as much as possible within those limits.

Jeff Clavier's comments on Bill's article addresses some good points on how to set up deal-flow with universities and research centers, and on the Entrepreneur In Residence strategy as a means to obtain knowledge, focus and dealflow within important areas consistent with an investment thesis. As an EIR myself, I agree with Jeff's observations on this topic.

Posted by barney at June 6, 2005 8:28 PM

This entry was posted in the following categories: Venture Capital

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Comments

An interesting analogy and framework. Just finished a Cont Ed course at Stanford called 'Starting up Startups'. Each week at least two VCs and/or Angels gave presentations and were followed by the moderator (Steve Bengston from PWC) with some interesting statistics/comments. Clearly the VC community is in transition (some say retreat) and have adopted extremely conservative review parameters. In fact there are some initial gating criteria such as referrals, 5+ customers, management team in place, product in production, etc that fly in the face of the nature of 'venture' funding. It was almost universal that referrals were important if not the key to being considered. I believe these tendencies are the result of lack of depth/experience in the domains and technologies being considered.

Side comment. A number of older more experienced VCs, when asked what the key factor behind successful ventures was, responded - luck. Not an easy criteria to nail down but it is obviuosly in play.

Given the flow of submissions through VCs it seems that establishing a criteria/framework is good but it will get over-ridden (or by passed) by referrals and such. I believe the success of a framework will be related to the evaluator's depth of knowledge in the domain/thesis. Upfront experts are probably not something VCs are comfortable with because they (almost) universally seem to want to control things. The human factor is always the greatest unknown.

If some of the studies are true and over the next 3-5 years 50% of the VC will disappear it creates an interesting situation. Will the survivors be deal flow or thesis oriented? There seems to be not change in current mindsets so I would suggest deal flow will die out and the VCs willing to bring in SMEs earlier will survive.

Posted by: Keith Sutton at June 8, 2005 1:05 PM

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