The art and science of venture investing – #2: the search for great companies and great opportunities

By ssyc1
August 31, 2017
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Why is it so hard to find great opportunities? Why are big success stories and sustained growth still so rare?

What is the “formula” for improving our chance of backing a company that has the potential to become a great success*? How to find companies that have the potential to keep on growing?

There of course is the analysis done by McKinsey in 2014 showing 17 companies out of 3,000 software companies (that have survived) achieving over 4 billion in sales: “In an industry that sees an extraordinary number of start-ups, very few go on to become giants ….only 28% reached US$100 million in annual revenues”. We add to this that “survival bias” means that the actual percentages are likely to be lower (i.e. some of the start-ups fail and go bankrupt and McKinsey couldn’t have captured the data – so our bolded qualifier above is very important)!

Investing in great markets vs investing in great teams: which is a better strategy? These two criteria indeed represent that stylized “market vs team” debate that has become Silicon Valley folklore: that on one side are those investors represented by a top-tier firm who believe that being in the right market is the number 1 contributor to investment success and others on the other side represented by a 2nd top-tier firm who believe that finding the right founders / team is most important.

Our thoughts on the “team” part of the equation were summarized here. Furthermore, some investors think that good entrepreneurs will help them identify the right markets and that a particular market is created or transformed precisely via great entrepreneurial efforts. It implies entrepreneurs drive the creation of markets.

While there is important truth in this, our team is rather agreed on the importance of “market” too. While we see a lot of perils in herding and chasing after the “hot sectors”, our own entrepreneurial journeys and investing experiences have strongly informed a view that being part of a “wave” and catching a good part of it is important.

Collectively, we have been involved in a number of success stories and almost all of them had “good timing”.

We have also sometimes passed on deals with a good team because we felt they were doing whatever they are doing “too early” or “too late”.

Finding great markets to invest in is important for a number of reasons:

Numbers #1. If an industry is growing at 30% or 50% or is expected to do so, then good companies / above-average performers are likely to grow even more.
Choosing the right entrepreneurial opportunity vs choosing the right investment opportunity. Because we don’t think all entrepreneurs make great investors, we think there are some limits to relying on great entrepreneurs’s choices to drive our investment focus areas.
Numbers #2. Is there any trade-off between growth rate and addressable market? We have been invested in companies where both were present. There need not be. A big wave is always good and offers more opportunities.
Industries poised for adoption “take-offs” tend to have hit a certain part of the cost curve. In other words, entrepreneurial efforts are greatly helped by other conditions such as cost trends (e.g. significant and accelerating cost reduction) as well as other more internal factors including the founders’ ability to bring on the right “scale-up” team at the right time to help grow the business (e.g. Facebook).

Of course, great teams plus great markets do not make great investments. Being careful with valuation and terms and shareholding structure and all of that …. taking are over any operational risks that can create reputational risks … and the uncontrollable risk of a peer having problems dragging the whole sector …. perhaps that’s why the top performers in this game will always outperform the “machine-enabled” venture investor ….

Perhaps that’s also why those who’ve been doing it for a while talk about a “recipe” rather than a “formula”. There is a science but there is also an art.

* We’ve deliberately avoided framing our thinking around the concept of a “unicorn” because that is about market valuation and not necessarily represent the most important metric of a company’s long-term success.