Ron Washington: It's incredibly hard.
Is the Venture Capital Deal Flow system broken? Yes. Can it be fixed? Yes. Is it simple to fix? It's extremely hard.
First things first though.
How much money is consumed upfront by doing deal assessment? Common belief says it's about $15B-$20B every year, with about 60% on legal and accounting work, and the rest on company analysis.
In other words, $4B - $5B are spent every year on deciding what, how much, and where venture capital should be invested. That’s quite a number to behold.
But while the number makes sense, the methods that are used for analysis are quite mind boggling. In fact, they are not mind boggling but, actually, mind blowing. And not necessarily in a good way.
The venture capital industry is predicting and propelling global innovation. It only makes sense to try and understand, really understand, if the decision making process of these investors reflects the market their investments are supposed to create.
As it turns out, there is a huge gap between the innovations driven by venture capital and the methods according to which venture capital is tunneling to investments.
Think of professional sports, it has long been moneyballing. Statistics, data mining, and innovative analysis tools are hard at work trying to optimize global talent into farm programs, team and individual success. Athletes use personal performance tracking devices and staffs are planning, monitoring, and training athletes based on objective performance indicators. The results? A huge leap forward in every parameter and in every professional sport, not to mention the exponential increase in commercial success.
But why stop at professional sports? Cab rides are Ubered (yes, that’s a word now) based on stats. Taxi stations are gone for good, customers are getting better service, and the market is only growing. Craigslist and the like have pushed realtors to the margins of the market and eBay & Amazon are doing to retail chains what video did to the radio star. All of these, by the way, will continue to be fueled, first and foremost by venture capital.
However, for the most part, venture capital itself has not changed its deal flow practice in quite a few decades. It is still overwhelmingly dominated by word of mouth, a trusted ring of “mavens”, hired analysts, hearsay, rumors, personal beliefs, subjective philosophies and little, very little, real-time, curated, solidified, uncontested data.
And that, ladies & gentlemen, is a real problem.
So why are the funders of innovation lagging in using the technology they fund?
Fear of change - For the same reason old baseball scouts objected to moneyballing. How can a computer replace eyes and instincts with decades of experience? Plus, they feel their system already works Many investors know and trust a few advisors and make decisions based on an accepted sequence and circle of trust. Fear of replacement - And what happens if the computer does pick better than a scout? Or an angel investor? And a venture capital partner? What does that mean for the future of venture capital firms?
Quality of Tools - Most tools, truth be told, are not good enough to trust with hard earned money, certainly not without human monitoring.
“Intuition by Recognition” - Some investors have, indeed, developed certain expertises that are incredibly difficult to replicate. Let’s face it, if you’ve been a partner with Sequoia for 20 years, chances are you have developed an excellent nose for good companies, markets and timing. Problem is, though, very few investors have spent 20 years in Sequoia.
As tempting as it is to point to these reasons as an excuse to not innovate their methods, venture capitalists who will not start using tools as a profound part of their day to day process are, modestly put, shortening their careers.
Data is available, directories are updated, and LinkedIn, Google, Glassdoor, YouTube, SlideShare, app stores, traffic monitoring tools, sentiment analysis,and investor databases are all out there. In today’s market, venture capital is no longer a closed guild and venture capitalists are no longer freemasons. If they don’t start using data - or more accurately put, intelligence - they will find themselves behind the curve much sooner than most of them would imagine.
Imagine a professional athlete that still follows 60s norms - smoking, drinking, unmonitored exercising - while competing for a roster spot in 2016 elite sports. Sure, ‘Messis’ and ‘Iversons’ will always make the cut, but for 99% of the market, free styling is no longer an option. Unless, of course, they enjoy getting their asses kicked by the lesser talented yet higher motivated.
So, let’s look at what a venture capitalist needs to go through before making the right choice
Discovery - Not so long ago, if you started a company, you would look for “someone who knows someone who knows someone at a some VC everyone knows”. Today, with much less money required to get started, entrepreneurs face thousands of openly reachable VCs and millions of angel investors, using tools such as Angelist, crowdfunding, Crunchbase and others to notice and get noticed. Sure, the old incumbents will still claim they “know every good deal because the companies come to them,” but even they know this has been a false statement for a long time.
Time allocation - Investors can meet, say, 100 companies per person a year. Some can meet more, though with the danger that at such a rate they will stop noticing innovation before noon time even if it hits them in the face. The problem becomes more severe, because their choice of which 100 companies to meet in the first place is almost exclusively dependent on the companies that proactively approach them. Sure, some do operate a lead generation program, but most don’t. Imagine a sports agents who only gets to represent the athletes that know about him, give him a call and ask to meet. How successful is that agent going to be in a market with millions of angels?
Qualifying the companies - Hmmm. Credit checks, history, references, competition, stage of the company, how real are their claims...a lot of verifiables happening here.
Qualifying the market - First, is there even really a market? Customers? Who are the competitors? What is their status? Ability to execute - How much money will it really take to make a difference in said market? What is the regulatory situation? How far is the technology from realization? How protectable is it?
Qualifying the company's own projections - Yes, companies produce their own presentations, which are a very important tool in understanding not only the company but how the company plans to navigate its way to successful disruption. One problem though is that companies’ presentations are marketing materials. The competitors are carefully chosen and so are the strength and unique propositions. All of these need to be crossed checked by an objective analysis and, guess what, the two perspectives are usually very different. As a matter of fact, the difference between the perspective provides quite a few insights on its own.
Timing - Sometimes things just don’t come together at an initial point, but may fit together at a later one. This could be because of doubts about the company's technology, executive management, market situation or - alternatively - changes to the investor’s own situation. Timing is perhaps the most important element in facilitating investments and is often overlooked or simply missed.
So how are companies evaluated today?
Well, in too many cases they’re not. Not really. And there are far too many preventable mistakes. This is for a very simple reason - today’s system is broken. First, let’s look at the following present day methodologies:
Friends - The first and biggest decision making factor today is still friends and peers. Most investors have “friends in the know,” but how much can friends really know about an ever changing market with millions of moving parts? Friends can still be a good place to start culling opinions and perceptions, but acting purely on their advice is not sound financial practice...nor is it necessarily good for friendships.
Gut - This instinct built into our anatomy can be a great indicator and worth listening to. But it isn’t exactly objective about the market or the viability of a business plan. Once you know the facts, then the gut can play a part. Sometimes you’ll be able to deduce the obvious weaknesses, but that isn’t gut, that’s brains. There are times when the gut will tell you something is off but your brain just hasn’t caught on to exactly what yet, and that’s a great time to follow it. One more thing about guts - they’re more trustworthy when bearing bad tidings than optimism.
Experience - It counts for a lot to have experience, but that alone isn’t normally broad enough for definitive decisions. No two situations are ever completely alike and the possibility of making snap judgements based on similarities without appropriate weight given to the differences is very real. The ability to review data without preconceived notions is just as beneficial as with the experienced eye.
Simple Directories - There are a number of online references out there today that can be a good way to get research started but, again, they simply aren’t going to give the big picture. Crunchbase, for example, often provides key information about funding and founders but it suffers from two basic issues. The first, being that it’s a sort of wikipedia of companies, is that it simply isn’t always accurate. Second, in addition to information being missing and/or outdated, it completely lacks analysis, leaving investors with a snapshot that is neither reliable, nor insightful.
Hired Analysts - So while there are numerous CrunchBases and Datafoxes out there, all of this research is still actually crunched by people. Obviously, human insight is necessary, but manually processing tons of data is so 1996...and so costly. The better the tools, the better the analysis. And not just better analysis, more analysis, broadening the opportunities that can be presented to the investor.
Bottom line - would you trust a doctor that collects his knowledge from friends, diagnoses with his gut, uses WebMD.com for up to date research, and consults with the same set of 5 colleagues? No, right? Same applies here.
So, how should it be done?
Before you bring your gut into it, consider adding the following approaches:
Linkedin - In addition to getting to assess the relevant experience and bad headshots of a company’s employees, LinkedIn also provides numerous useful insights. Important breakdowns that can be obtained include many factors in a DNA comparison, such as seeing the balance a company has between management, development, operations and sales, and where these employees are located. A quick sort of the data and you can see, for example, that engineers are in Israel, sales are in London, maybe with a lone ranger in New York, and, oh my, it’s all incredibly top-heavy with CXOs and VPs outnumbering the engineers.
Google Trends - This oracle of pretty much everything does more than search, it tells you who’s searching what. As a part of the aggregate data needed for a big picture, it’s very useful to see if people are searching for this company at all, or at least for a solution to the same problem the company is trying to solve.
Credit checks and scoring - This is just how it is these days. A bank wouldn’t lend someone money without checking this, so why would you invest in a company where founders have loads of illogical outstanding debt and/or a string of business failures on their hands. If they couldn’t get it together enough to pay American Express, your brain and your gut might be chiming in to say they might not be so skilled with your money either.
Market surveys - These can be incredibly useful. Many ideas are good and you may even be able to imagine yourself using it but, face it, you’re a data sample of one. Market surveys are crucial to having any reliable insight (besides your gut) as to whether the wider public includes enough customer who will really use the product and at what price point. Don’t take the founder’s word for it when there are now so many channels for obtaining market sentiment.
Expert networks - Even if the audience says they are interested, getting third party, unaffiliated expert insight is crucial. Even the greatest team of analysts cannot cover the entire set of expertise required by every corner of the market. Say the public wants wireless charging for their laptop. And they want it now. And they’re willing to pay a nice sum for it. Well, the company’s founders are saying they can do it but an analyst needs to hear from a top tier expert engineer in the field of wireless charging that the technology is workable, integratable and affordable within the near future.
Benchmarking - Having an organized method for placing a company in relationship to its competitors in terms of team, technology, market, ability to execute and vision is also vital to understanding its worth and viability. The ability to obtain fast and accurate data on the competitors in order to organize this and have insight into the lay of the land should be a focus of your investment analysis.
As a part of bringing all of this information and analysis together as a meaningful practice, efficient processes have to be put in place:
Scale - You want to get the process to a point where you achieve the same level of consistency for all your deal flow and make a notable increase in the number of companies you can analyze when looking for the big deal.
Tracking - Create a system that allows you to set aside companies you didn't fully like for a particular reason, say your expert said the technology or market was not quite ripe, but one that can change over time. A good tracking system would be able to flag and alert for a second review over time, particularly if set factors change.
Or...Zirra - Because we do all this. When you want information on a company, their market, and even their entire competitive set, we pull together the raw data while simultaneously performing pertinent market surveys and gathering expert opinions from our top-notch network. All of this is integrated efficiently into a digestible profile of the company and a report that paints the full picture of the DNA of the company, the product, the market and projected valuations alongside a fair portrayal of their potential risks and success factors. Boom, it’s done. Put your feet up, read the aggregated insights, expert and crowd wisdom and now the knowledge and the power is in your hands. Now you can go with your gut, if you so choose.
So, let's aggregate all that:
So, in a world where cab drivers and sports players are making the most of all the automated data driven analysis tools, what sense does it make that venture capitalists would not seek a similar quality of insight and efficiency when considering where to invest? There are a number of tools out there that can give you the data, but one Zirra that can pull it all together for you seamlessly. To not utilize these advantages now means you’ll be burning the midnight oil pouring over papers while the competition chugs ahead faster and faster, leaving you with a stack of missed opportunities or, worse, a trail of regrettable decisions.