Jeff Fagnan (Atlas Venture), Bill Burnham (Celsius), and Ravi Adusumalli (SAIF) recently shut me down for suggesting that a portfolio company’s team is more important than the company’s market opportunity.
Me: “If the market doesn’t work out, a good team will find a new market that does.”
Them: “Venture is about identifying large new markets. Why do I want to invest in a good team just to have them end up struggling to find a good market for their product? I would rather invest in a good market in the first place.”
Me: “Good teams identify good markets. If you’re looking for a good market, look for a good team. The quality of the team signals the quality of the market. Its a tautology. And if the market doesn’t work out the way you predicted, a good team can work around that and find a new market for their product.”
Of course, investing in a good market, good team, or good technology is not an either/or proposition. Venture firms with good dealflow can invest in companies that are strong in all of these factors.
But they were right. A good team signals a good market but it doesn’t mean the market is good. The investor has to take responsibility for that judgement. It would take me three hands, twelve foots, and nine CFOs to count the number of good teams in shitty businesses.
Negative Signals in Venture Capital
I believe Don Valentine once said something along the lines of “I look for markets that will grow so quickly that a company will succeed even if the management ends up doing a so-so job or the technology doesn’t word perfectly.”
If a company has bad management, yet somehow the company makes lots of money, the market (or technology) must be extra good. The market is so good, a dog could run the company.
Likewise, if a company has bad technology, yet somehow the company makes lots of money, the management or market must be extra good. The management could sell ice to an eskimo. Or customers want the product so badly, they will buy it even if it is half-baked.
There are multiple dimensions that determine a company’s success: team, market, technology, competition, acquirers, and so on. You need an n-dimensional space to visualize this. Since n is greater than 3, we can’t draw a picture.
Jeff suggested projecting this n-dimensional space onto 2 dimensions. Assume we only care about the team and the market. Pick a specific value for the other dimensions: assume the technology, competition, acquirers, and the rest all rank good to excellent. We are left with a 2-dimensional projection:
Team |
|||
| Market | bad | good | |
| bad | Turnaround or give up. | Find a new market. | |
| good | A white hot market can alleviate management problems. | Does the team or market deserve the credit? Also, a rising tide raises all boats, including the competition’s. | |
Negative Signals in Biology
Bad management in a money-making company is a negative signal of the company’s market or technology. The worse the management, the better the market or technology must be.
Kevin Laws’ VentureBlog article, Why Are Startups Like Peacocks?, describes negative signals in evolutionary biology. Specifically, why are peahens attracted to peacocks with big beautiful tails? Tails have no purpose and they get in the way when a peacock is trying to escape predators. Tails are a defect that evolution should have weeded out. Peahens should be avoiding peacocks with beautiful tails because their children might end up with big useless tails too.
However, a tail is actually a negative signal of the smarts and strength of a peacock. If a peacock has been able to survive with a major defect like a big tail, it must be really strong and smart. A tail is an easily observable negative signal of peacock qualities that would otherwise take a lifetime of observation to discern.
Kevin argues that the feathers in a startup’s tail can
“include a high quality board of advisors, a good law firm, a good bank, management with a past track record, or the first paying customer. While all of these things can be very valuable to a startup company, their value to a venture investor can appear out of proportion to the value they bring through their work. As a result, sometimes it may appear that management is sacrificing the long term goals of the company to establish the feathers necessary to get funded. In that case, they really can be peacock feathers — things that may slow down long term success, but that only good companies can take on. In certain models where significant funding can make the difference between success and failure, those actions may be required to succeed at all.”
A “high quality board of advisors, a good law firm, a good bank,” are all nice to have but I don’t believe most investors take any of these factors too seriously. “Management with a past track record, or the first paying customer” are obviously very important but it is not wise to use them as signals. Good management and paying customers simply reduce the investor’s uncertainty before he invests. Good management and paying customers answer questions like “Am I going to be able to get a good CEO to run this business I like?” and “Is anybody going to pay for this #@!)?!#@ thing?”
I don’t think good investors look at signals and I don’t think Kevin is advocating they should. Smart investors judge a market opportunity and then try to reduce their uncertainty of the elements they need to attack that market: a good team, good technology, weaker competition, and so on. But I do agree that companies may have to make their tails prettier to attract investors in future rounds who may have different investment criteria. Such as a momentum investor.