English translation: make a LOT of small bets in order to win. (Even if most of those bets are losers.)

Now, this sounds somewhat counter-intuitive to a lot of folks who have been trained to “think like investors:” after all, the more deals you do, the less of a special snowflake you must be, right? (And we all know, Private Equity Professionals are the Specialest Snowflakes of All.) Furthermore, doing more and more “losers” in order to scrape together more winners (rather than trying to avoid losers altogether) just grates the wrong way at the investor mindset.

Well, Sim Simeonov has rejected that mindset with his Simeonov sim. (Forgive me.) But the point of my post isn’t just an emulation of Sim’s simulation. It’s that he’s right despite his simulation math. Rational VCs should be doing as many deals as possible, true, but it’s not due to portfolio IRR; it’s in spite of IRR.

No, the real reason that rational VCs should be doing as many deals as possible is that, to a large extent, VC firm survival has been dependent more on appearance than on financial reality. Specifically, assume two similar firms on their 2nd or 3rd funds, and assume they both, 5 years in, go out to raise funds with a 20% IRR. However, Firm A has earned that IRR through a risk-averse, lower-beta type strategy, while Firm B earned that IRR with a much larger “shotgun” portfolio chock-full of duds, but with a tiny sliver of a Google or similar mega-hit. Which firm is going to be able to raise the next fund with more certainty?

How things have worked to date is that LPs fall in love with great stories, and so it’s more important (in general) that you have one great story in the portfolio (even if it’s for a small investment) than that you have a bunch of sleepy, boring stories that average out to the same return.

Now, I’d love to see what savvy upstream investors like the Super LP, for example, think of this theory: it’s certainly not very flattering to the LP community if you suggest that they make investments solely on “stories” and not on “math.” In the LPs’ defense, I don’t think they’re being lazy or stupid; on the contrary, for the first several decades of the VC industry’s life, the market was so inefficient, and the data were so very sparse, that “stories” were the only reasonable data to look at.

However, we now have a VC (and super-angel, and micro-VC, etc.) industry that is chock-full of history, overflowing with data, and crowded with participants in the marketplace who will (relatively) quickly compete for new niches (especially as the squeeze of a denominator effect and general anti-VC enantiodromia are felt). I no longer feel as strongly as I once did that we’d soon have algorithmic VC decisions, and I doubt that we’ll see a “robot uprising in venture capital.” But I do hope and believe that we will see a more disciplined industry, and one where VCs’ incentives get rearranged to align better with actual financial returns (rather than with “stories” that drive fundraising).

(I do happen to know that there are institutional investors who realize the “great story bias” and are seeking to exploit the inefficiency it creates… let’s just say that if you were going to exploit it, you might look quite hard at Revenue-Based Finance as the way to do so

Happily, the math involved here is pretty low-key (algebra, the highest level of mathematical reasoning to which VCs are required to aspire).

One of the best VCs I know always aspires to be the lead investor. Being the lead investor means you’re the de facto coach, quarterback, and ringleader for that round’s investor syndicate (and likely the entire board). He also tries, both as lead investor and as board member in general, to be a coach, if not confidant and mentor, to the CEO. This is all in addition to the normal duties of a good board member: meetings themselves, prep for meetings, often board dinners the night before, regular if less frequent contact with non-CEO executives (diligence and prudence), recruiting etc., and of course, any audit/comp committee work.

What kind of time does this take, on a monthly basis (4.3 weeks/month)?

• Weekly CEO calls: 4.3 * 30 min = 2.15 hrs
• Board meetings q 6 weeks, plus prep: (3 hrs + 1 hr) * (4.3 / 6) = 2.87 hrs
• Massaging the egos of other board members before/after: 30 min * (4.3 / 6) = 0.36 hrs
• Monthly CFO or other exec calls: 1 * 30 min = 1 hr
• Executive recruiting (2 major searches a year, taking 10 hours min. each): 2 * 10 hrs / 12 = 1.67 hrs
• Committee work (2 meetings a year, taking 3 hours min. each): 2 * 3 hrs / 12 = 0.5 hrs
• Go to one industry conference a year: 8 hrs / 12 = 0.67 hrs

This is the bare minimum theoretical lower bound that you can consider as the time requirement to be a good, lead investor VC board member: 9.1 hours per board, per month, or just about 2.1 hours a week.

That is for the perfect, steady-state, frictionless world: board meetings are in your town at your firm’s offices (no travel), you do not raise a round, and there are no crises. A more realistic assumption would be to add:

• Meeting travel q 6 weeks (MINIMUM, even driving up the 280 from Menlo Park to the city takes some time): 1.5 hr * (4.3 / 6) = 1.1 hrs
• One crisis OR new round per year: 20 hrs / 12 = 1.7 hrs
• Actually “adding value” like you said you would (soliciting customers, buyers, investors, etc.): 2 hrs /month = 2 hrs

So the real-world minimum adds another 4.8 hrs / month, bringing us to 13.9 hrs /month or 3.2 hrs / week.

How much do VCs really work? I think it’s fair to suggest that VCs work at least as much as other ambitious but affluent, socially-encumbered, and non-hourly-billable professionals: probably on the order of 50-60 hours a week. Let’s call it 55, which would reflect the combination of 10 hour days, 5+ hours each weekend, and a long and/or exotic-enough vacation each year to brag about with the other nouveau-affluent in your social circle.

The real-world catch here is that VCs have to spend a minimum of 5 (and as high as 12) hours at weekly partnership meetings. Let’s call it 6 hours/week to be charitable.

55 hours total – 6 hour partner meeting overhead = 49 workable hours.

49 workable hours / 3.2 hours per board (real world minimum) = 15.3 boards.

So there we have it: 15 boards is the upper bound of what a VC can probably sit on. HOWEVER, this assumes 100% of his working capacity is devoted to board work — nothing here for new deals or fundraising (or for other exotic and occasional pursuits, like strategic planning, learning and research, or leadership and mentoring of junior personnel). That estimate of 15 boards also has what I call the “conceit of optimality,” or inverse-Murphy: it assumes that the crises, new rounds, etc. do not overlap and create impossible time-crunches.

Given that fundraising is THE existential requirement of VC firms, and given that new deal work does have to happen somehow (after all: how did those 15 investments get made??), you’ve got to make significant provision for the working time of a VC to those other, non-board priorities. I personally think that non-board work is at least HALF of the workable hours, but I could be convinced that a board-seat-heavy partner might spend 2/3 of his time on board work.

Therefore, I think that 10 is the maximum realistic board seat capacity of a VC partner who wants to do a reasonably diligent and good job on boards, while also doing the minimum to stay in business as a VC. In practice, I think many boards will take more-than-average time, and I think most VCs will need to spend more time on non-board work, so 7 or 8 is probably a better number to set as a prescriptive maximum.

One could exceed ten board seats without f***ing up in exceptional cases:

• Independent angel investor (no “firm” overhead)
• Exceptional geographic and/or industry concentration
• Evergreen fund, wind-down of a fund, or other nontraditional partner role

Otherwise, you are going to be dropping packets on the floor like a Cogent router in a SQL Slammer epidemic.

One probably needs to hold significantly FEWER than ten (or even fewer than 7) if the following hold:

• Geographic diversity (have to fly to board meetings)
• Industry diversity (trying to stay up to date and mine contacts in diverse fields)
• Series A/B/C rather than later stage weighting (hypergrowth, “chasm,” hiring, and fundraising challenges).

In this case, there was a new CEO recently signed up to work with a technical founder, there were some family relationships on the team and board, and there were some international complexities (overseas offices). I also believed that there were some cultural issues in the company that needed work (especially around customer service / customer experience issues).

Now, compare these things to the usual, “hard,” “objective” issues that VCs take: market size, defensibility / patents, growth rate, capital requirements — things that can generally be reduced to numbers. My concerns looked pretty “soft” in comparison: seasoning of the team working together, culture of customer satisfaction, family dynamics. I took a risk and laid it out there, adding that I would be happy to check in in a few months to see how things were shaping up on these “soft” issues (but I acknowledged the risk of losing the deal to a faster moving investor).

The entrepreneur’s reaction was mixed. At first he told me he appreciated the candor, but then, in a follow up email, objected pretty strongly and negatively contrasted our communication with other VC “passes” he’d received, each of which had a “hard” reason (like raising too much / too little, outside of geography, etc.). I thought about this for a bit.

If you were pitching, and the VC declined to proceed at that time, would you rather get a “hard” or “soft” reason for a pass?

I’d say “soft.”

If a VC tells you, “ah, you’re raising 10-12 million from two VCs, but my fund size will only let me put in 2-4,” or conversely, “you’re raising 2-3 but I have to put 4-6 to work in each investment,” what have you actually learned? With due respect, you’ve been told that your would-be date has to wash her hair on Friday. Perhaps, in fact, she is going to wash her hair, but if she was really attracted to you, she’d rearrange her shampoo schedule.

Likewise, total market size, IP, or the elusive “traction” are all “hard” reasons for a pass. They’re likewise convenient: they are impersonal / objective, deficient to some extent in all startups, and theoretically required for success. Each is a seed crystal around which a swirl of “soft” reasons can easily and apparently crystallize. And they all sound good, well-reasoned, prudent — things we can easily feel OK about mentioning to our partnerships or to you, the entrepreneur.

(Not that this is disingenuous or untruthful in any way on the VC’s part; since we must reject literally 99% of deals we look at, sometimes one reason is as good as another.)

BUT: if you can find someone willing to take a risk and share the “soft” reasons with you, have a close listen. Soft items include team dynamics, opinions about “direction” or “strategy,” or “pattern recognition” stuff. Sometimes it’s about a “smell factor” or something else that just makes a VC uncomfortable. Always, it’s a complex cocktail of different perceptions, judgments, and opinions (from the discounted cash flows to Lord Keynes’ “animal spirits”), and the true contents are much more varied and harder to describe than a single crystallized hard reason that’s dropped out of solution.

These things are risky for an investor to try and describe. They can be personal or interpersonal, and talking (or listening!) directly about one’s own self is hard. They often include a personal value or judgment call on the investor’s part, and those calls can prove wrong. However, in fundraising as in so much of startup work, perception is (or at the very least strongly feeds back into) reality. Getting an honest assessment of what one investor really, truly thinks at the “soft” and complex level is likely to be more helpful in shaping the business and the pitch than a pat “hard” answer.

Sometimes, things just don’t align and the real answer is: no fit, let’s both shake hands and move on quickly. And sometimes, there’s a complex swirl of doubt but the time and effort of dissecting and parsing it isn’t worth the likely yield: crystallizing on a “hard” rationale for a pass is fine. But if an investor takes the time to dig in, to do the “mass spectrometry” on the trace elements of his doubt, please listen. He’s taking a risk, and though the soft observations may be wrong, the mere fact of their existence and elicitation, as well as their details, should be valuable to the entrepreneur.

(The next step is getting VCs to solicit, appreciate, and iterate/improve based upon “soft” feedback from entrepreneurs. Which I am trying, the reader may have concluded in surmise, myself to do. The entrepreneur I describe is real and gave permission for me to mention him anonymously.)

Well, I call B.S.  The problem is that Steve starts with a bunch of unobjectionable and demonstrably true statements, then starts layering in misleading or irrelevant stuff, and concludes with what is essentially nonsense.  Observe:

“… Venture Capital firms have honed their skills and strategies to match Wall Streets needs …”

“VC’s make money by selling their share of your company to some other buyer – hopefully at a large multiple over what they originally paid for it.”

“[during the 1995-2000 IPO bubble,] old rules of building companies with sustainable revenue and consistent profitability went out the window.”

“… the number of venture firms soared …”

True. VCs are businessmen.  We respond, like all businessmen, to price signals in the market, and when pricing indicated demand for new IPO issues during the bubble, VCs responded.  More people entered the VC market as a result of seeing these price signals.  That these price signals were amplified by bubble psychology is clear, but hardly novel: the Dutch did it with tulips back in the day, and half the country did it with houses in the last few years.

“The boom in Internet startups would last 4.5 years – until it came crashing down to earth in March 2000.”

“For the next four or five years [2003-2008], technology M&A boomed, growing from 50 buyouts in 2003 to 450 in 2006.”

Misleading.  The boom in Internet company deals stopped in 2000, but those companies (except for the most egregious flameouts) by and large still existed in 2001.  And the M&A “boom” that Steve refers to is a chimera.  VC-backed M&A peaked for that period at $32 billion in 2007, yes — but this was still down from totals of $41 and $69 billion in 1999 and 2000, respectively (that’s M&A alone, independent of the IPO bubble; source: NVCA 2009 Yearbook).

Plus, it is entirely appropriate that a “boom” in tech M&A should follow, with a 5-8 year lag, a boom in VC investment.  All that Steve shows here is that the VC investments that were made during the first Internet bubble, on average, did in fact build companies that later were sold.  In fact, 2004-2006 is probably a pretty appropriate example: with our ~ $14 trillion economy, growing by ~ $420 billion a year (3%, though sadly not this year), it’s entirely reasonable to expect sustainably to generate $10-20 billion a year worth of M&A in the highest-growth sectors.

“… since the bubble, most VC firms haven’t made a profit.”

“… the message of building companies that have predictable revenue and profit models hasn’t percolated through the VC business model.”

“… [you should suspect that VCs are] trained and raised in the bubble and M&A hype and still looking for some shortcut to liquidity.”

Just plain false.  First, Steve confuses VC firms with VC funds.  Most all firms manage several funds.  The #1 correlate of a particular fund’s returns is its vintage year.  When you look at VC as an entire asset class, it’s like looking at performance numbers for mutual funds: most of them (with the same basic focus / strategy) perform pretty similarly based upon how the markets did in a given year.  A given fund having lackluster returns in a lackluster vintage year isn’t broken; it’s how the system works.  VCs’ upstream investors are asset allocators and make steady investments in an asset class year after year, and are richly rewarded for their patience.

With respect to the implication that profitability needs to “percolate” through VCs’ thick skulls, I urge you, dear reader, to talk to any VC-backed CEO.  I double-dog-dare you to come up with an example, outside of perhaps the top 3 or 4 highest profile growth cases (hint: think “tweets” and “pokes”) where his VCs are not harping on cutting burn, boosting margins, and getting to breakeven.  Heap all the abuse you want on VCs, but we’re not stupid — our “business model” is to respond to market demand.  If exit markets want Webvan and eToys, great; if they want six quarters of profit growth, great.  “Eat all you want, we’ll make more.”

I don’t know how Steve puts his pants on in the morning, but I don’t know of any shortcuts.  Until the magical pants elves start helping me with my trousers, I put them on one leg at a time.  And, as soon as the liquidity fairies start pointing to magical shortcuts, I’ll take them, but I sure as hell don’t know where they are.  “Companies are bought, not sold.”  Does a buyer want to buy an unprofitable company?  Great, if the deal is legit and satisfactory to the shareholders — but that’s called an exit, not a shortcut.

Finally, let me address Steve’s ultimate incongruity: the notion that under-40 VCs are “trained and raised in the bubble and M&A hype.”  I’ve already shown that there was little, if any, unsustainable M&A hype in the mid-2000s (though perhaps 2007 got a bit frothy).  So, disregarding that, we’re left with the “raised in the bubble” (1995-2000) argument.  Well, look: there are essentially no long-term jobs in VC for anybody under the age of 25; those few firms who hire IROCs (intellectuals right-out-of-college) generally treat them as “pre-MBA” positions with a guaranteed kick-in-the-ass after 2-3 years.  So what kind of current VC was “raised in the bubble?”  Let’s take a 27-year-old banker/MBA type who was hired in 1996, and so got a solid bubble indoctrination.  How old is he today, as 2009 draws to a close?  That’s right; the VC who was “raised in the bubble” is now 40 years old.

A modest proposal: maybe you can’t trust any VC over age 40.  Better stick to those of us who started our investment careers after 2000…

• REAL VCs have committed funds from stable, liquid, institutions who are not going away (state governments, universities, pension plans, countries).
• REAL VCs have partnership agreements that last 8-10 years and aren’t tied to the current level of the NASDAQ or the price of anyone’s house.
• FAKE VCs are everyone else who claims to be a VC but isn’t like the above.
• FAKE VCs may be nice people but since they aren’t REAL VCs, you don’t know what you’re dealing with in working with them. So be cautious and “know your investor” if you are going to rely on them for your short- to mid-term capital needs.
• Don’t sweat it; unlike the financial economy, early stage firms are inventing and creating and building things to sell in the real economy. Yes, you’d rather sell your company into a bubble. But great companies are often built in downturns and sold in upturns. Keep building and selling.
• All the REAL WEALTH that humanity has ever created has been the result of new invention and teamwork. All of this CDO/MBS/hedge fund nonsense is just pushing around money. You, the entrepreneurs and inventors, are the real engines of true wealth creation and we VCs are honored to play a role in helping you do so.

All of this seems at least as true and relevant today as in the first days of October. So let’s all take a deep breath and keep this in mind: human ingenuity (Founders, CTOs, Visionaries) conceives new wealth; human effort and discipline (Engineers, Salesmen, Managers) bears it into the world; and the acceptance of it by markets (Customers, Sponsors) makes it viable and sustainable. VCs play our own humble role by advising the foregoing and making calculated risks of our (and our investors’) wealth and time. This is a GOOD THING, and furthermore, this is a cycle that despite its rough edges CREATES NEW WEALTH. That is not the case with all of the now-trashed asset classes (which were largely about flipping the same old bad ideas to one another) and the whining rent-seekers who (mis-)managed them.

If you’re reading this, you’re almost certainly a geek or a startup-world person. And that means you, like me, have a unique opportunity and burden to do the right thing in this crappy economic time.

So, please. (This goes for me too.) Turn off CNBC. Close the browser window for Yahoo! Finance. If at all you can, block out this volatility and pandemonium among the wealth-re-arrangers. And, please, focus and redouble your efforts on creating wealth and value that ultimately will be what allows our humble race of tool-wielding mammals to conquer ignorance, disease, malnutrition, isolation, Malthus, and generally the heat-death of the Universe.

This reminds me of an early experience I had at Voyager. We were looking at a company that was building an online search / social media app. They talked about people using it for various applications — consumer, enterprise, small business, blah blah blah. We were just about to the end of the pitch, when I asked pretty straightforwardly: “So, what’s the sex angle here? Is there an application in dating or porn?”

The room went silent.

I pushed on, oblivious to the mood that had just chilled like a shot of Jaeger down an ice luge. “You know, like VHS, or modems for BBSes, or early adoption of Web marketing tricks like affiliate programs and popups,” I articulated despite the intrusion of my foot now rapidly entering my oral cavity. “Is there a strategy for accelerating adoption around that content?”

The founders were visibly uncomfortable. Mercifully, my boss was not pissed, just bemused. “I … I guess people could use it for other things, too,” said one of the founders, finally. Handshakes all around, a quick note on our investment process, and we’ll get back to you after next week’s partner meeting, ciao for now.

Oops. Back at the office, this is addressed.

“Randall, in the venture business, we have certain things we don’t talk about, and certain things we don’t invest in, due to a number of reasons.”

At the time, I’m thinking: OK, VCs are pillars of the community, have to show up at the Opera, at the charity events, at the B-school reunions, and can’t be branded pornographer or such. I filed this away under the “shit not to talk about, Einstein” filter, along with ever admitting to listening to Journey, or denigrating tattoos while speaking to anyone whom you’ve never seen fully naked.

But now, Paul Kedrosky gives me a flashback and with a key piece of insight. It’s a follow the money moment: “… until the venture business is funded by groups other than pension funds, trusts, and endowments (ahem), the likelihood of mainstream VCs ever getting beyond flirtations [[with the sex business]] is vanishingly small.” Yep, follow the money. The paymasters here are the Prudent Men, the real stodgy guys, the Trustees and the Chairmen and the Stewards and the Overseers.

And frankly, this is probably a good thing. It’s a little like the Senate. You don’t want the country entirely run by a bunch of pasty old white dudes, most all millionaires, 60 years old and who won’t be fired for 12 years (on average), and who probably still think that Kudzu and the missile gap are our biggest national problems. But you don’t want a bunch of whippersnappers on the make driving all your big decisions without recourse to the accumulated wisdom of years past.

The real test will be if one of the trendsetter endowment funds like Harvard or Yale green lights a VC or PE investment that targets the sin sectors. If that ever happens, then the VC business will start to get a lot more (directly) involved in the naughty bits…

(To those of you who don’t know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC’s check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you’ve grown it to something more than our investment dollars.)

His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly.

How can this be? I’ve seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn’t reasonably informed about prefs.

Let me construct an example. Say that you’re a first-time entrepreneur, and that you don’t have anyone on your exec team, nor on your board of directors, nor among your existing investors, who’s ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let’s say, you get hold of a term sheet that casually throws out there something like “holders of Series A shall be entitled to an amount per-share equal to two times the per-share price…” and you don’t know what it means.

Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort — not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC’s looking for — for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he’s not going to deposit more than a few hundred $k in the bank, and that’s at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund).

Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I’m about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you’re a brilliant businessman who’s going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can’t be bothered to read and understand a term sheet — including seeking savvy legal counsel when appropriate!

Now, having said all this, there are at least two cases where Leo’s thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.)

The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm’s length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple.

Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of “anonymous Asian industrial families” is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn’t mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don’t apply.

If you’re not dealing with a real VC, read everything three times and have your lawyer read it six.

The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you’re hot and heavy with a company, once you’ve raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers — only to find that revenues aren’t ramping up fast enough and you need cash — OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need — and when the sharks will smell blood.

That is when you will get the predatory term sheet.

If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you’ve got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital.

In a nutshell, VC is this weird parallel universe into which there are very few wormholes. (To start a career in VC) It helps to distort the space-time continuum with an extremely concentrated mass of money that you already have.

Venture capital as an industry deals with momentum investing. Paul Kedrosky has argued on his Infectious Greed blog that VC is a “bubble business,” and that venture returns, when they’re good, come from momentum-fueled exit events. This is an argument where the counterexamples are the exception that proves the rule: Google’s IPO (unimpeachably a deal that stands on its own merits rather than a momentum exit) stands out for having decisively ended the exit drought that had plagued the industry since 2001. Indeed, GOOG going out kicked off the recent positive-momentum exit cascade that gathered steam throughout 2006.

Likewise, on the “entry” side of new financings, momentum tends to rule the day (especially when exit momentum “spills over” into fundraising and new financing activity). See, for example, the cavalcade of YouTubettes that have been trotted out, freshly funded and hoping to hit warp 10 and slingshot off the perceived stellar performance of online video and user-generated content. (Indeed, it would take some backwards time-travel for most of these to capture any fraction of the value in that particular space.)

It is easy self-righteously to laugh at the absurdity of funding 30 YouTubes. But if we accept whole-heartedly the ad absurdum version of Kedrosky’s argument, we can’t blame VCs for believing in momentum. After all: if folks today are buying online video companies, then the savvy VC better have one to sell.

But investing is not a game played alone, and contrary to the bluff and bluster of some VCs, no deal is “binary.” Every deal is implicitly an auction, with a bid and an ask, and the formula for investment return is ancient and venerable: buy low, sell high. Momentum helps with the latter, but crushes our ability to do the former. Apart from the occasionally perverse incentives provided by large, fixed fund sizes, pricing going in is even more leveraged in ROI than pricing coming out. Getting into a good deal at an attractive price — and hence, the longer lever on ROI — depends on a virtue diametrically opposed to momentum, namely, contrarianism.

The contrarian looks for undervalued purchasing opportunities by ignoring or subverting the prevailing wisdom of the day. He makes it his job to call the tops or bottoms of markets, and sometimes is the one declaiming the emperor’s nudity. An occupational hazard of this is that sometimes, the market has a ways to go yet, and occasionally the emperor still has flesh-colored tights on — and early is the same as wrong when timing markets.

Certainly, if there is a mythical hero of venture capitalism, it is the steel-nerved visionary contrarian who makes what looks like a long-shot bet, boldly doubling down when others are fearful, and propelling forward great companies and great technologies that nobody else dared touch (and hence, that he invested in on the cheap). Where else do we get the nerve lionizing our asset class as “venture?”

So, we are faced with a contradiction between the mythology of our industry and the harsh reality. You don’t get to be both the visionary contrarian and still have the online video portfolio company. Why do so many venture firms seem to choose momentum in this tradeoff?

I have two theories. One is that, although entry price has more theoretical leverage over ROI than does exit value, exits are so much more visible that they dominate the consciousness of most VCs. That is, given the implicit opportunity to make a 8x ROI on, say, a $60 M exit, or to make a 2.5x on a $500 M exit, and assuming that the probabilities and amounts are adjusted to keep other comp and performance measures ceteris paribus, I bet that VC decision processes are strongly skewed to the big dollar, highly visible exit. Half-billion IPOs are much better bragging fodder at the VC confabs than mid-market M&As, even though the latter may well pay off better. This would be a great master’s or Ph.D. thesis if one could substantiate and measure the value of this skew.

The second theory is a general theory for understanding why contrarianism, itself, is “meta-contrarian” (that is, why contrarianism is selected against as an investing style). I call this the “rich friends theory.” I use it to explain why, despite all rationality, U.S. investors tend to overweight U.S. equities in their portfolios. In a nutshell the theory is this: it sucks far worse to miss out on an investment opportunity that all your friends have scored on, than it does to miss out on an equally profitable opportunity that everyone else missed, too. Put another way, it’s awesome to get richer than your friends, but it’s way worse to get much poorer than them. Thinking of this “peer-relative risk aversion” helps to understand a lot of bubble / momentum dynamics. This, too, would be fascinating to measure, although I can reasonably set a lower bound here of 0.7% skew toward the crowd, which is the “rich friends tax” you pay in incremental house edge at craps by playing the pass line (the “do’s,” where most players play, has a house edge of 1.41%) vs. the don’t pass line (the”don’ts,” almost diametrically opposed to the do’s, where winning earns you enmity and losing earns you jeers from your fellow punters, has a house edge of 1.40%).

There’s also a case to be made that emerging managers hew more closely to the herd because it could be an existential crisis to a firm for its first fund to be a “fourth quartile” performer. Much better for a new firm to post median returns and live to raise more funds, than for it to risk lagging returns on a series of contrarian bets (better, that is, for the firm, if not for its investors, who may in fact be better served by the longer-shot odds). This is, of course part of the “tyranny of IRR,” about which I have another blog entry under preparation.

I wish I could say that understanding, or even measuring, these effects gives you some kind of instant edge in investing. But, alas, this is a perfect example of the occasional frustrating impotence of mere understanding. (I do have some ideas for exploiting this particular case, but those obviously aren’t public.)

If you’re thinking of doing this, remember that we (VCs) are not your personal sales channel into our portfolios! Consider:

• VCs generally take a board seat at most; we influence our portfolios, not control them, and we do so at a fairly high and abstract level.
• Most VCs abandoned the “incubator” model after the ’90s bubble; we prefer that our portfolio companies seek the best service providers for their particular needs rather than establish some sort of Gleichschaltung.
• We ain’t in it for charity! We’re trying not only to build and sell our portfolio companies, but to seek out new deals, with new capitalizations, and to boldly go where no man has gone before! (er, sorry.) Star Trek aside, this takes up our time, so even if your shiny new product (or dreary old service) is really groovy for a portfolio company, unless it gets them to an exit or gets us a new deal, it’s probably best dealt via a different contact.

Now, all that said, there are some cases where using VCs for leverage into their portfolios does make some sense.

• You have some particular specialized characteristics that suit one VC’s portfolio well. This could be a mix of geography, stage, domain expertise, etc., like, say, a life sciences IP law firm that caters to early stage firms in Botswana might find affinity with a VC with that same focus.
• Your sale is at the board level. C-level recruiters come to mind (although this is emphatically not guidance for recruiters to start badgering VC board members).
• You have some referenceability within the world of VC-funded startups. These people talk to each other, go to work for each other, and start companies over and over with each other. Your sales into big companies (even tech) or lifestyle businesses (even small “startups”) are not representative of what the experience with a VC-funded firm will be, and won’t necessarily reference well among such firms.
• Your offering will almost certainly speed a company to exit at an excellent valuation (hint: you can’t, or else you’d be a champion VC yourself).

What should you do if you decide to make the pitch?

• Do your homework — it’s fairly trivial in most cases to discover a VC’s portfolio and the specific investors (partner) on each board.
• Use your homework — figure out which portfolio companies you have a great deal for, and make your pitch to the specific investor affiliated with that company.
• Reference successes and, ideally, get referred in. Find other venture-backed companies that you did an amazing job for, and, if possible, get the CEO or VC board member from that company to recommend you. This would be the holy grail introduction.

I personally try to be helpful to decent and courteous sales / biz dev folks, but I think that reading and acting on the above is a bare minimum level of courtesy for sales / biz dev people talking to VCs.