Lessons from the VC Industry
In earlier articles we discussed the purpose of product portfolio planning and the frustrations with current product portfolio planning. In this article I’d like to look outside the typical world of product companies to a related industry that is in the actual business of making product investments, and that’s the Venture Capital (VC) industry.
First, just so we’re all on the same page, realize that just as the management of a technology company must decide what projects to fund in order to try to maximize shareholder value, the partners in a VC firm must decide what startups to fund in order to try to maximize the return of their investors. So the purpose is very similar, even if today the methods are very different.
Now just like any other industry, some venture capitalists are much better at picking successful product investments than others. But as an industry there is a reason they’ve made so much money. They are not afraid to take calculated risks, and as a whole over time they’ve proven themselves able to produce some pretty terrific returns.
I work with quite a few different venture capitalists from several different firms, and while the practices do vary across people and firms, there are some best practices that have emerged that I would argue have been critical to their effectiveness as portfolio managers.
What are some of the key lessons from VC’s?
– Seed Funding and Product Discovery
VC’s have a very clear distinction between seed stage funding and later stage funding. They know that just because an idea sounds good, it doesn’t mean that the customers will respond the way they hope, that the team can come up with a good solution, and then execute successfully. Some VC firms (as well as Angel investors) focus on this very early stage funding, and others focus on later stage funding.
Contrast this with the typical corporate product portfolio planning, where the management is forced to make all or nothing investment decisions very early in the process with very little real information.
Essentially the VC’s are evaluating opportunity assessments, and seed funding is there to underwrite product discovery. If the idea pans out, and the team proves capable, later stage funding is intended to execute on the idea, get the product to market, and help the product reach its potential.
– Evaluating Opportunities
While every individual venture capitalist looks at investments through his own lens, as an industry VC firms have learned that there are some dominant factors to predicting future success: the magnitude of the market opportunity, the capability of the team and their ability to execute, the promise of the product concept and the intellectual property behind it, and the ability to acquire customers at a reasonable cost.
Significantly, this view of opportunity evaluation is markedly different than the typical corporate assessment involving financial models with detailed plans, pricing, revenue and cost estimates.
At first blush it may seem that the VC analysis is too subjective, and the corporate view is much more analytical, but I would argue that a) the accuracy of a typical corporate financial model created as part of a product proposal is an illusion, and b) the factors that the VC’s are digging into may be qualitative but they are the true determining factors.
Most importantly, the VC’s know that whatever your plan may be today, it is almost certainly wrong and will need to adjust. As you proceed and learn, you’ll need to course-correct based on changes in the market or the technology. VC’s understand and embrace this dynamic and encourage flexibility.
This is in stark contrast to most product companies. Once most companies put a plan in writing, they feel the need to execute on it as it was written – regardless of the learnings from the market, the team and the technology. The company effectively put blinders on, and either ignores change, or even places obstacles to change.
– Willingness to Accept Failure
VC’s know – and expect – that a meaningful percentage of the opportunities they back will fail, and that a few projects will generate the vast majority of the returns. This is completely at odds with how most companies do planning, and there are a couple important implications of this.
First, the VC’s understand that it’s okay to fail, but it doesn’t make sense to throw good money after bad. What’s not okay is to live in denial and to continue to throw funds against bad ideas at the expense of being able to give the good ideas the investment they need to reach their potential.
Second, knowing that many projects will fail, the VC’s spread the risk across a portfolio of investments. Since a VC firm typically has a portfolio of 30-45 companies, they are able to take a portfolio-adjusted view of risk. This allows them to take some really “big swings” knowing that they are part of a risk-adjusted balanced portfolio. Most companies, on the other hand, don’t apply portfolio theory to product portfolio planning. Companies tend to be defensive trying to protect what they have (downside protection) and think very short-term, rather than taking the offensive and going after the key new opportunities aggressively.
– Investment Time Horizon
While everyone loves an investment that yields a great return in a very short amount of time, there is a dramatic difference in the investment horizon between VC’s and typical corporate product planning. So many in our industry were shocked that Apple had invested more than 3 years to develop the first iPhone model, and I can’t tell you how often I heard “our company would never fund something that wasn’t expected to contribute within a few months.”
Yet in the VC world, the investment is generally expected to take years to develop. Part of this is directly related to risk, but also I think there is a better appreciation in the VC world for the concept that building something worthwhile may take more than a quarter or two.
In fact, the average VC technology investment takes over six years to realize its potential. Creating something great requires persistence and focus, and VC’s strive to have clear milestones and clear inflection points in order to monitor the success of their investments.
– Investment Granularity
In the corporate world we often worry about funding at a relatively small granularity of incremental or ongoing investments to existing products. This effectively moves a level of decision making away from the product team to senior management, and it also tends to disincent longer-term strategic thinking.
In the VC world, the decision is whether to invest a given amount (typically a relatively large amount) in a team to chase an opportunity. The VC’s know that the team will have to make course corrections as they go, and they in general try hard not to micro-manage.
– Partner Sponsorship
Another interesting lesson from VC’s is the way they handle the due diligence process and then the decision process. First, if you can’t convince a partner that your idea is good, you go nowhere. But even if you do convince a partner, you’ve still got more to do. That partner becomes your sponsor or champion at the VC firm. That partner will often eventually serve on your board if they do invest, but most importantly, this person is responsible for deeply understanding your project and defending it to the rest of the partners.
This notion of executive sponsorship is missing at many companies. In larger companies, this is often the kiss of death because without a strong sponsor in the executive ranks, you are subject to the political winds, and are almost certain to lose in the next squeeze for resources.
– Partner Dynamics
Just because you have a sponsoring partner doesn’t mean the VC firm will fund you. They will have extensive debate, with you and also behind closed doors. This is where the typical corporate hierarchy can hurt because it tends to significantly reduce the type of open, honest, constructive debate needed to make smart investment decisions.
In a typical VC firm, the partners will vote on your project. Some require unanimous decisions and others don’t, but in either case they make a decision as a team and while you’ll continue to have your partner as a key contact and board member, you find that all of the firm’s partners are there and available to help. They genuinely want you to succeed. They have skin in the game, and there is much less room for politics.
Some of these differences of course stem from the nature of private investment firms versus product companies, but I have found great value in identifying and leveraging best practices in software wherever they might be found, and when it comes to product portfolio management, the track record for most product companies is poor and painful, yet VC’s have built an entire industry around this critical skill.
In the coming articles we’ll discuss how to apply these practice in a corporate environment.
Special thanks to a couple of my favorite VC’s (and former leaders of some great product companies) for their contributions to this article: Josh Kopelman of First Round Capital, and David Orfao of General Catalyst Partners.
