MONEY TALKS by Andrew Waitman

Deep down when we stare into the daunting reality of what we do, we realize that the venture business is really a business of grinding. Building businesses from scratch where once there was nothing at all is not easy, but it is rewarding if done well. And we never stop dreaming of black swans.

WaitmanHighEdit-111X196.jpgFashion, grinders and black swans
From SCAN's Print Edition

Insight often comes to those who identify patterns in life. I will share with you a venture capital success pattern that I’ve observed. Venture investors make money from three types of outcomes: fashion, grinders and black swans.
Fashion outcomes are most common but, like necklines, are constantly changing. They occur when a herd-mentality takes hold in new and often over-hyped market areas such as telecom, Internet (dot com) and, most recently, web 2.0 and clean tech. The dynamics of fashion attract many characters and start-ups, some good, many less so. It is a particularly fertile time for charlatans and promoters to assemble obscure academics who have been toiling away in arcane, intellectually stimulating but commercially impractical areas that have suddenly become fashionable.
With a willing suspension of reasonable due diligence and gobs of gullibility, many investors pursue ideas and businesses that during the fashion cycle seem amazing, popular and important. Following the bubble’s inevitable implosion these ventures appear dubious at best and ridiculous much of the time. Savvy VCs reap rapid and significant returns during these periods. Investors pour in money during the hype/fashion cycle and many start-ups are taken public relatively quickly or purchased by acquirers caught up in the mania. Think Internet bubble and the auspicious date of April 1, 1999, Yahoo! purchases Broadcast.Com for a cool $5.7 billion from Mark Cuban, who shrewdly converts to cash immediately upon sale, as do his venture investors.

The venture capitalist makes money because investor-herd enthusiasm and valuations surge through the entire food chain, increasing the appetite of individual investors and institutions for IPOs and of large corporate buyers for M&A. This phenomenon was abundantly evident during the telecom and dot com bubble, driving both large-company boards and management to pay exorbitant prices for concept companies that in many cases evaporated. Nortel’s numerous failed takeovers following its only successful acquisition, of Celtic House backed Cambrian Systems in 1998, is a vivid example of that period’s excess. Many venture capitalists became heroes of their portfolio with Nortel’s and other large acquirers’ “what-were-they-thinking” acquisition binge.

Like a supernova’s spewing new celestial bodies, fashion frenzies sometimes spawn new and valuable black swans (For a description, see The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb). Black swans are the Googles and PayPals of the start-up world and, more recently, Skype, YouTube and Facebook. Black swans are the power-law, winner-take-all super start-ups; king makers of the venture midas list. They rapidly create massive sustainable new giants and in doing so, create extraordinary returns for investors. They are rare and random and there is no investment strategy that unequivocally optimizes their creation because of the uncertain and unforeseeable conditions necessary to produce them. Complexity complicates causality.

The final way venture capitalists make money is the least glamorous, most difficult and time-consuming, and yet the most important, as it can be studied and optimized. I characterize it as the grinder way. It is the patient, persistent building of real new companies in important, sometimes unfashionable, market spaces, grinding away every day at the wall of skepticism, obscurity, and conventionalism. These start-ups create value by relentlessly fighting against the inertia of people's resistance to new ideas and apathy toward changing how they currently think or do things...people naturally minimize effort.

These start-ups are building value one customer at a time trying to achieve the elusive goal of $100 million in revenue in under 10 years. These grinders fight for attention from investors, interest from customers and participation from experienced executives. It is rarely easy because there is no overriding fashion trend convincing investors, customers and executives to ignore their normal risk aversion and jump on-board. It is a daily grind to win credibility with investors, customers and executives ─ all necessary to attain the ultimate goal, which is to build a real, sustainable and substantial new business.

We venture capitalists dream about black swans, and are thrilled if our area of investment focus gets fashionable because this improves the odds of a black swan. Often we jump ship into fashion trends under the rationale of “a change of strategy,” though this in itself is fraught with its own risks and dangers. However, deep down when we stare into the daunting reality of what we do, we realize that the venture business is really a business of grinding. Building businesses from scratch where once there was nothing at all is not easy, but it is rewarding if done well and we never stop dreaming. Next column I will discuss some of the challenges of engaging US venture investors.

Andrew Waitman is managing partner of Celtic House Venture Partners, specializing in early stage investments in high technology companies.

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