“Life can only be understood backwards; but it must be lived forwards.”
― Søren Kierkegaard
A few blogs back I wrote about valuations, how they are determined and how crazy they have been. In that piece, called Unraveling the Magical Mystery of Valuation Math, I talked about how valuations of private companies are derived and, specifically provided my informed-by-22-years-in-VC Venn diagram of how this math works.
One never knows when they write whether they are actually writing fiction or non-fiction. You strive for accuracy on the non-fiction front, but there is always a tendency to embellish a bit to tell your story. Until there isn’t. And to that point…
I was moderating a panel at a conference recently; it was comprised of 4 venture capitalists, all of whom focus on the healthcare field. How I know that my last valuation post was better than non-fiction is due to the answers I got in the final lightning round of the panel. That’s when I asked each panelist to give me their one sentence answer to whether they believed private healthcare company valuations would go up or down in 2022. Here are their answers:
- Up, but more selectively; there will be a flight to quality
- Sideways – not down, but not further up
- There is so much money available that it’s hard to say down, but maybe down a little
- Down (implying way down)
So, in a nutshell, three of four futurists who are betting people’s money based on their assumptions are…definitely going to be wrong.
This really goes to the heart of what is challenging about venture capital, and not just in the healthcare field. The mountain of assumptions that is built on top of facts is so high, that many funds have results that look like a Vegas craps table on a Saturday night. Sure, there are some big winners, but for every 2 winners, there are 10 other people who are going to slink away thankful they at least got some free drinks. (more on that at this post).
People don’t think of venture capital as a low-risk endeavor (hopefully), but they also want to think of it as a way to get rewarded for having an all-in, throw caution to the wind and bet on the big transformation play strategy. Entrepreneurs get really annoyed when investors seem to be engaging in risk management, which is what they are doing when they say your new venture is too early, hasn’t demonstrated the ever-popular product-market fit, has too many competitors and has too little evidence of efficacy.
Given the fact that even the best futurists are still mostly guessing, it’s a tough role to play when you are shepherding other people’s money (and your own – many people don’t realize it but VC’s are usually required to put substantial amounts of capital into their own funds in order to get outside investors to write them checks – it creates an alignment of incentives of sorts). Some people are especially good at this future-thinking and have a better than average result. But the real insurance that you can deliver decent returns, at least, is having a large portfolio. Multiple shots on goal is itself a risk management strategy, as is having a syndicate investing together and reserving capital for future rounds. When you ignore these three tactics, it’s like taking Steph Curry out of the game in the first quarter.
If each venture investor had some magic lens that enabled them to buy low and sell high every time, that would be something special. But even the best of the best make bad bets some times, and it makes everyone else in the field feel a little better when they do (let’s be honest – schadenfreude is everywhere). I was speaking to someone about a fabulously failed company recently and what went wrong there, but it was hard for me to argue that this won’t happen again and again rather than say this was a uniquely bad example. Risk management is an art and most decidedly not a science, especially when it comes to early stage investing in a world where things can change dramatically more or less overnight (pandemic anyone?).
With a rip-roaring stock market and crap-loads of cash available for investment, it is understandable why investors conclude that we haven’t reached the pinnacle yet. With a rip-roaring stock market and crap-loads of cash available for investment, it is also understandable why some are standing around with a sign saying, “The End is Near.” The real answer is “who knows?” Investors do their very best to make good, educated assumptions and to selectively back those they believe will be great managers, but even that last one is tough. How often have you thought someone you know/work with/date is awesome only to find out that they always leave the toilet seat up, never reach for their wallet at restaurants, and never put their own dishes in the dishwasher? My point exactly.
Given all that, investors have to learn to rely on a combination of knowledge, instincts and hope, and apply a bunch of their own elbow grease to help the companies manufacture and capitalize on luck.
But when forced to answer a question, we must put our cards on the table, Vegas style, and reveal our betting strategy. And that’s what results in an array of answers like the 4 noted above. For Limited Partners looking to select funds, it’s those kinds of questions that you should be asking. Track record is nice, but it is not always a predictor of future performance for all the reasons noted above and more. But at least knowing where the investors in a fund stand on the future-thinking spectrum helps you know where to place your own bets, at least culturally. If you think the responses crazy, you are not talking to the right fund manager, unless you enjoy thrillers.
Caveat emptor, as they say. If you ask 4 people to answer a question and you get 5 answers, you must look for a sign. Which sign do you choose when the options are “The End is Near” or “The Future is Bright”?
“The future is there... looking back at us. Trying to make sense of the fiction we will have become.” ― William Gibson, Pattern Recognition