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March 15, 2010

I wrote a post on Sunday about Why the VC Business is like a big game of Texas Hold’Em. As folks pointed out, it’s not a perfect analogy, but there are major similarities because of the interplay of skill and luck and the advantage derived from early successes.

But here’s the reason this structure makes it difficult for new entrants in the business: Skill beats luck over time, but most new VC’s only have a few shots to prove themselves.  VC’s typically make only 2 investments each year, and newer VC’s (including both new GP’s and Principles) aren’t that productive early on.  At the same time, these investments carry a lot of weight early in one’s career.  ”You only have a couple bullets, so use them wisely” is the common advice.

This doesn’t really jive with the dynamics of the industry and kind of encourages risk averse, mainstream behavior.  Also, because success begets success, it sometimes allows folks who aren’t necessarily very good at the business to get out ahead quickly with a lucky win, and then ride the coattails of that success for a while.

Now, I don’t think there is really a realistic solution to this.  Startups take a long time to develop, and so it would be unrealistic to give a young VC tons to time to see if they are good over the life of a portfolio of investments.  Also, senior GP’s take a lot of other subjective signals into account when thinking about elevating a new VC to a more prominent position.

Still, something doesn’t quite sit right with me with the status quo.  In any case, it’s the reality and new entrants need to deal with it.  Having said that, I have observed some good strategies that seem to work for some of the up and coming investors I know.  Here are three that come to mind:

1. Make a lot of investments. This is a pretty smart strategy I think.  Since there is a lot of chance in this business, and it takes a long time for investments to mature, it behooves a new VC to get as many shots on the board as possible in a short amount of time.  This allows the benefits of a portfolio to take hold, and provides a decent possibility of a quick win.  The downside is that if a number of investments go sideways, it’s easy for your colleagues to make the case that you have no idea what you are doing.  Also, you could hit a really bad moment in the economic cycle that could crater a bunch of your companies.  

2. Be Different.  This is my favorite.  The reality that I haven’t mentioned yet is that not all VC’s have access to the same deals.  So it’s really not like Poker, where every player has equal chance to draw the same cards.  New VC’s have the deck stacked against them because most great entrepreneurs would rather go with a proven success than a new up-and-comer.  So, one strategy for a new VC to take is to be radically different from one’s peers in terms of the stage they invest in, sector, evaluation criteria, or some other meaningful vector.  It’s a difficult bet to make, and one that’s really hard in a partnership unless others buy-in to your contrarian approach.  But I think this can work. Take Y-Combinator.  When it started, a lot of VC’s scoffed and said that Paul Graham was investing in dinky little companies and buying tiny ownership.  But his approach was radically different, he attracted a completely different kind of entrepreneur, and seems to be doing pretty well.  Oh, but remember – Paul did this himself, he didn’t have to content with a partnership of VC’s with a different mindset, which gave him a lot of freedom to pursue his strategy. 

3. Get access to hot deals.  Easier said than done, but it’s the typical approach to success, I think.  One way to do this is to have the right professional background.  If you’ve held leadership roles in Google, Facebook, or DoubleClick, it’s more likely that you’ll be able to invest in a buddy of yours who is starting a company. Even if it’s hotly contested, your friend may give you an allocation, or you can make the case that you have something unique to offer because of your experience.  Another approach is to do series B or C deals and pay up for great entrepreneurs.  This is a viable strategy as well, and funny enough, was the advice I got when I started in the venture business (advice that I ignored because it didn’t seem very fun). Another is to closely track an up-and-coming VC or angel investor and find a way to be their go-to investing partner.  In each of these cases, it’s easier to get these deals through a partnership because there’s nothing like a competitive deal to get people’s juices flowing. 

All of these strategies (and others not mentioned) work – since new hot VC’s do emerge and do just fine.  But I do wonder if some potential great talent gets lost because of the dynamics I described in the beginning of this post. 

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