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June 16, 2010

Quick post today that came to me on the subway.  During my time in Venture Capital, I was surprised to see how many “rules” there are that have become gospel in the industry.  At the same time, I was surprised how little convincing evidence there was behind these rules aside from common industry wisdom. 

But markets and businesses all change, and venture capital is no different. Rules change, and players that fail to adapt become obsolete.  I remember when guys like Union Square Ventures and First Round Capital starting breaking some typical VC rules, I heard folks at other firms voice a bunch of criticisms that seem pretty silly in retrospect. 

The funny thing is that when everyone plays by the same rules, it creates market opportunities for those who can figure out how to defy the rules and do so intelligently.  It’s just supply and demand.  

Below are a couple “rules” that I think are worth breaking:

1. “We only invest in consumer companies that have a live product and traction”. 

Ok, this is actually a relatively new rule brought on by the capital efficiency of internet businesses.  But I think investors have swung a bit too far in this direction.  This rule basically means that you will only invest in a) things that are really on fire and you have to pay way up for and/or b) things that have traction but have no obvious business model. It’s a strategy that has worked for some.  But I think that this tends to disqualify some really ambitious products that just can’t be launched without meaningful investment.  Also, “traction” doesn’t just mean a lot of users. I’m usually much more impressed with a company with few users but really interesting unit-level metrics vs. something of more scale that could just be a flash in the pan. Finally, I think that some of the risk of investing in something pre-product is reduced by backing a team with a really good product process suited to the discovery phase of the business.  Oh, and a good early stage investor should be perfectly comfortable and helpful in implementing this process. 

I like how one angel investor described their focus on Venturehacks: “Strong preference for pre-product teams led by product-minded folks”. Refreshing. 

2. We only invest in companies going after billion dollar opportunities. 

I’ve blogged about this one before. I have two thoughts here.  First, at the early stage, investors honestly have no clue about whether a company has billion dollar potential.  What look like dinky toys to some can turn out to be monster companies, especially when the company is inventing markets, not capturing share of existing markets.

Second, the fact that most VC’s are going after companies of this scale (which they need to given their fund sizes) it says to me that there is a funding inefficiency for companies that can exit comfortably and capital efficiently at sub $100M levels.  By the way, this is where the bulk of M&A activity happens.

In my view, because of my first point, quite a few companies that may seem to be mid-sized exits might actually turn out to be venture scale.  Also, there may be some really interesting market segments out there that no investor is spending time in because it doesn’t meet this threshold (but perhaps reliably churns out mid-sized exits with reasonable risk).  

And by the way, since when was a $50M exit considered “small”? That’s pretty darn good for an entrepreneur, and will free them up to make a huge swing next time. 

  • Author robchogo
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