The New York Times “Bits Blog” had an article this past Sunday titled “Disruptions: Tech Valuations Defy the Restraints of Reality.”1 Unfortunately, this short read paints a broad brush of the Venture Capital industry and plays to a few of the oft-discussed and unflattering stereotypes about venture capitalists (…as if there was any need for fuel to be added to the raging fire stoked by Republican presidential candidates.)
The article lays out a number of problematic investment rationales pursued by some within the VC industry. Among the rationales listed are:
• Investing only based on a “herd mentality and a yearning to be a part of a potential next big thing”
• Investing in a company “so they can stick the logo on their Web site”
• So-called “spite investing” when you invest in a company “simply because they were not given the opportunity to invest in the competitor”
Do these practices go on? Clearly they do, which is why the failure rate of venture capital firms can exceed 50% during some periods2 and so few earn solid returns on investment. However, it would be unfortunate to paint the industry with such a broad brush. The few bad apples with money to spend, but not the sense to invest it wisely, should not pollute the image of an entire industry.
A number of successful (and tenured) VCs have spoken in classes at Michigan, and they have consistently preached the polar opposite of the approaches noted above. Their principles are simple: don’t follow the crowd, be true to your investment analysis methodology, and be steady in how you invest your money. Quite apart from the investing process described in this article, these VCs described the process as akin to “courting a significant other” in order to become personally close with the founders. They also spoke of the industry’s increasing talent. Many VCs have built their own companies or have been executives at Fortune 100 companies.
Will that approach counter the ills described in the Bits blog? It will not. If it did, everyone would be taking the same approach in an industry notorious for breaking the mold. However, those principles will help you avoid turning a venture capital portfolio into a junkyard of failed investments and, apparently, it will also prevent you from running with the rest of the herd (50% of which won’t see its next meal).
In the post dot-com crash and Sarbanes-Oxley world, companies are staying private longer. This allows companies to develop into real revenue-generating businesses without being scrutinized by public markets. The days of “pets.com” are history and also the irrational exuberance that came along with them. VCs that succumb to irrational investments fail, as they should. So, while the article seems to paint the whole lot as a bunch of crack pots, the truth is that the industry is full of extremely successful investors. Otherwise, why would there be so much money entering the market in first place? Success breeds copycats.