Marc Andreessen on Venture Capital - how it works, VC investment rules

Marc Andreessen, of Netscape fame, is writing a blog. Today he wrote "The Truth About Venture Capitalists" which explains how the VC business works, what types of businesses should take VC money, and how VCs decide which companies to invest in. I have written before about 'The Economics of the VC Business" which drives how they make decisions.

Andreessen says "VCs investment selection strategy has to be, and is, to require a credible potential of a 10x gain within 4 to 6 years on any individual investment -- so that the winners will pay for the losers and in the timeframe that their investors expect."

VC success is measured in some ways like baseball players. Baseball is the only sport I know of where you can fail 70% of the time and be considered an outstanding success. A .300 hitter in baseball is a star performer, meaning they get a hit 30% of the time...and fail 70% of the time. Marc explains it this way "Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run. The base hits and the home runs pay for all the strikeouts."

VCs plan on hitting a home run on every investment they make. Just like when David Ortiz of the Red Sox steps up to the plate, he waits for his pitch, and expects to hit a home run every time. VCs turn down 95% of the companies they look at and only invest in the companies they feel have the essential elements for a "home run" success.  Realistically they know that historical averages will prevail and they will have some losers. But, at least at the beginning, every investment has the potential to be a home run success.

What are those essential elements of success? Each VC has a different formula but they boil down to this; Invest in great management/technical teams, with a product or service that solves a hard problem, in a big or expanding market. Home run potentials have all three elements.

VCs sometimes take a gamble on companies that  have two out of the three elements, but never when they have just one. For example, a VC might invest in a company that has a proven team, and a product/service that solves a tough problem, but where the market is small or unknown. Or they might invest in a good team, focused on a huge market, but the product/service seems flawed. But they will always require at least two of the three success elements be present.

Andreessen goes on to say that VCs turn down entrepreneurs for several reasons.

1. Can't see you getting to a sale or IPO with a credible prospect of a 10x return within 4 to 6 years.
2. What you're doing is too early or unproven.
3. Not convinced that you've assembled the right team to go after the opportunity.
4. Loves it but can't talk other partners into (investing) it.
5. Fully committed and doesn't have time to take on a new opportunity.
6. It would require traveling and she can't or won't do that.
7. You're in a market she doesn't know much about.
8. Had a bad experience with a similar investment in the past.

Remember, VCs pass on 95% of the deals they see. Like baseball players, they are waiting for their "perfect pitch" where they can hit a home run. This means they will pass on lots of perfectly good businesses that can ultimately be successful. They might even pass on a few "base hit" companies, and instead, focus on the "home run" potentials.

Every VC has a slightly different formula, and they see potential differently. VCs invest where they see the elements of success, and where they can use their experience and network to help the company succeed. Finding the right VC is somewhat analogous to finding the right partner in marriage. Shared vision, goals, and experiences help create a partnership where "home run" success is possible.

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Comments

[Peter Cranstone]

Fascinating stats - of the 100% of deals that come their way, they ignore 95% and swing on 5%.

It's really no wonder then that their returns for the last 7 years have been well below average. In fact most of them have not made money for their LP's.

I would recommend the following book - Fooled by Randomness. Whatever their criteria for swinging for the fences the book will illustrate why it's easy to be fooled by randomness.

Getting a home run is really, really hard work and timing.

Cheers,

Peter

[Greg Linden]

Good post, Don. In my discussions with VCs about Findory, I hit all of #2-4 pretty regularly.

And, sure, it makes sense. I understand how the VC incentive system works. Findory was an unproven technology with only a team of technologists (no marketing, no seasoned leadership).

If I were a VC, I probably would not have been willing to stick my neck out on that one either.

I understand the hesitancy to go after new markets or unproven technologies. It is hard to evaluate these kinds of startups and the risk is high.

On the other hand, if all VCs do is fund a known team in a market that several others have already explored and proved, they end up doing little more than jumping on the bandwagon, late to the party and overfunding the latest trends.

I have to wonder if VC investors would be better served if more VC firms devoted resources to the riskier prospect of evaluating and funding brand new technologies.

It almost certainly is harder, but it seems like the only way to discover and get on board early with something new and big.

[Umesh Kumar]

among my group of friends a few have tried startups either inside the university incubator, or with borrowed money from friends who are doing a job in US and started it out in india( the understanding generally being that you pay (nice interest + original) if you succedd else you pay (original) only )

i wonder how is it among other people who started out and continued without vc/angel funding?