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May 25, 2011

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Harry DeMott

Having walked on all sides of the investment line (I've been an analyst, a long short equity fund manager, a distressed debt hedge fund guy of various stripes, and a VC) it is interesting to see an analysis like this.

I would argue that the venture world is not as different as you might think in terms of what people invest in:


1. Margin of Safety - the definition of margin of safety is generally buying things at a large discount to what you think they are worth. Because VC's go for large scale wins - 10X and above returns, by definition, they are including a large margin of safety in their investments (yes the risk of permanent loss of capital is far higher - but so is the margin of safety if things work out)

2. This time is never different - I have yet to meet an investor who does not use his or her own past investment experience - and that of his or her firm as a touchstone when looking at new investments. when it comes to certain technological innovation - this time is different. In 1992 - you couldn't have youtube - simply not enough bandwidth - today it is a given.

3. Be patient and wait for the fat pitch - I'm not sure what the statistics are - but the average venture firm has about 25-30 investments in a fund over a 10 year span. My guess is that they review 100X that many plans - if not more.

4.Be contrarian - actually here is where I think VC's are probably more like any other investors. VC's tend to run in investment packs (how many group texting applications have been started in the past year? how many Groupon knock offs?), as do public market investors, and buyers of Hollywood scripts (Dante's Peak and Volcano in the same year - really!)you need the be mentally able to be alone and wrong to produce superior results.

5. Risk is the permanent loss of capital - absolutely. and for VC's this is why they structure investments not as equity but as preferred. A small margin of safety in an otherwise risky asset class.

6. Leverage - Tech doesn't use it.

7. Stick to your circle of competence - I think VC's fall down here. Too many don't properly apply this filter - trading positions across a portfolio with the thinking - well if I give in on that biotech deal to one partner, he'll vote for my group texting deal. Too little knowledge gathered in too few heads.

Here's where I think it all comes down to:

1. Capital is now a commodity. Used to be that getting a call from KP or Sequoia was like visitng the pope - now you can get capital from anybody and have an equal chance of success.

2. Technology is largely fungible. Used to be that tech was hard (it still is for me). But for people developing web apps - everything is coded upon a fairly standardized set of tools.

3. Ideas are important but not paramount. As soon as an idea is validated with funding or n open beta - it can be knocked off - remember no tech barriers.

4. It is all about execution and strategy - and this is where VC's need to focus.

So if you go back through your list and try and apply all of that to a new VC investment - what you really are asking yourself is the following question: is my knowledge of and strategic input into a company good enough that I can essentially derisk the investment and put it on an accelerated growth path which will lead others to realize the value of the idea and thus validate my heretofore imagined margin of safety?

If the answer is yes - then go right ahead - you very well may be alone and wrong - but chances are you will soon have a lot of company and be rolling in it!

Chris Douvos

Harry:
Your comments are always spot on!
That should be a post of its own . . .
Best,
CD

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