Swinging For The Fences

Joseph W. Bartlett, Founder of VC

Since the venture business started in a big way, in the late 1950's, conventional wisdom amongst the pundits and VC's suggested that the game is all about building "portfolio makers." To be successful, VC's had to master the art of investing only in those little acorns that grow into towering oaks, a.k.a. companies with market capitalizations in excess of a billion dollars. The notion that a few huge winners make up for the inevitable losers was based on General Doriot's experience at American Research & Development. In Doriot's case, Digital Equipment and High Voltage Engineering were the home runs that secured his legacy and delivered high portfolio returns. Absent those home runs with the bases loaded, a venture portfolio will fail to be competitive.

To be sure, there is a certain amount of truth in this belief. The performance of venture funds over the last several decades, as academic research has shown, is governed by the rule of 80/20 (actually 90/10). The top 10% of the venture funds have, year in and year out, achieved relatively sensational returns and the rest have suffered by comparison. Specifically, average returns over time on venture portfolios are generally 18-20% compounded; but the median amongst all venture funds is a good deal lower than the average. The thought has been that the top 10% have benefited by focusing on portfolio makers, for example Peter Crisp, in the early rounds of Apple Computer, Warren Hellman in Apollo Computer, and Ben Rosen in Compaq.

The idea of investing for the blockbuster is appealing, particularly in today's market environment when so many companies have flat out failed. If your portfolio is sinking like a stone, there is significant attractiveness in the notion of trying to pick one huge winner that will allow you to ignore the disasters. Moreover, a giant score can make an individual's reputation in the marketplace and in the trade press. One giant home run, like one perfect game, can put a VC in the Hall of Fame.

In fact, a simple piece of arithmetic illustrates the fundamental fallacy:

There are currently 400-600 venture funds with investible capital. However, billion dollar companies like Apple or Cisco or Intel come along once in a blue moon. In any given year private equity investors will be given a shot at no more than 5-10 companies that will ultimately wind up in the billion dollar category. If VC's focus only on the home run deals, they will never put all of their capital to work and they will miss golden opportunities.

Recently, I was at a meeting where an investment opportunity was presented to a first time fund with $50 - $60 million in capital commitments. One of the younger partners pooh-poohed the opportunity out of hand because his fund was "hunting only for elephants", i.e., that billion dollar "portfolio maker." If the opportunity were not potentially in that category, he was not interested.

However, my young friend was making a two-fold mistake. First, if you go hunting for elephants, you need an elephant gun. I pointed out that the likelihood of him finding the portfolio maker, and beating the trophy funds to the punch was statistically insignificant. The likeliest candidates tend to migrate toward the trophy funds because they can help "brand" an issuer when the company plans to go public or raise additional funds. If Greylock or Kleiner Perkins is an investor, issuers have a much easier time raising capital and launching IPO's. Secondly, his 100x return aim was implausibly high. By focusing on that alleged potential, he was inviting business plans that presented forecasts made largely out of thin air. Anyone can project a billion-dollar company by targeting a 1% market share of an aggregate market that Forrester Research projects to be $100 billion. But just because a business plan forecasts huge revenues doesn't mean those revenues are realistic. Some of the cardinal disasters in the last several years have been the result of investors looking beyond reality-based opportunities and believing (because that belief fit their models), that a billion dollars was within the grasp of a given start-up. Once you start believing what your model tells you to believe in this business, you are likely to fall off a cliff.

By focusing on these bogus business models, my young pal was ignoring the opportunities he should have been analyzing and favoring... companies that presented reliable projections that would, if anywhere near successful, wind up yielding five to six times the investor's initial capital. My pal would have understood that Manny Ramirez doesn't swing for the fences every time. Single, doubles, and triples are often the only productive strategy in baseball, as in venture investing.

It is true that venture capital has dried up in this ugly market climate, but, as is often the case, some of the decision making is irrational. If one subscribes to the time tested theory that the way to get rich is to buy cheap and sell dear, now is the time to buy, since prices are in the sub-basement. Moreover, now is the time to buy early stage opportunities because the maturation period is three to four years, and by then the market will have come back (or we are all in deep trouble).

Swinging only for the fences is not a rational reason to ignore solid investment opportunities. Slaves to that philosophy will wind up buying nothing at all, or shares in a company that is over the top in its forecast, and therefore, unlikely to succeed in this or any other environment. VC's should be looking for a variety of solid businesses that will deliver a strong return on capital. While home runs will help deliver high returns for their portfolios, the singles, doubles and triples are the solid foundation.