The challenges of bringing an operating mindset to venture capital

I’ve had two conversations this week with people from entrepreneurial and operational backgrounds who are looking to become venture capitalists.  They were smart people who I respect for their achievements and intellect, but I’m not sure their ideas about adding value to a portfolio of venture capital investments will work well in practice.

Before I start I want to make it clear that this isn’t a post about whether it is best for venture capitalists to have an operating or financial background – I think both can work.

I also want to get it clear that I believe adding value to investments is a key part of being a VC.  If you don’t add value you shouldn’t be in the game – you won’t get into the best companies and you won’t make the most out of the ones you do get into.  I like to say that half the profits you make as a VC come from choosing the right investments and the other half come from the value you add after the deal is closed.

But adding value to a startup isn’t an easy thing to do.  Over the twelve years I’ve been in this game I’ve come to think the best way to think of an investors job is helping the company (primarily the CEO) to be as successful as it can be.  Notice the careful formulation of words – the company has the success, it is in control and the help is ‘given’, which means it can be refused. 

The tendency of people with an operating mindset is to think about a portfolio of companies in a similar way to a company with a number of divisions, which results in a different approach.

The first manifestation of this approach is often is to look to synergies within the portfolio as a major driver of value add.  This means investing in a set of related companies which can add value to each other, thereby making the overall fund more successful.  There is a direct analogy here with the way that the divisions within a company help each other.  The difficulty with transferring this idea to a venture portfolio is that the way to make money is to invest in the best companies you can find, not companies that will work well together.  Additionally, portfolio companies cannot be forced to work with one another and instead choose to work with the best available partner, a company which is most likely outside the portfolio.  An further challenge is that startups are typically much more resource constrained than divisions within a company and are less able to undertake side projects to help out friends.  This is not to say that portfolio companies never help each other out, they do, and I remember a good collaboration between our portfolio companies buy.at and WAYN which helped us when we sold buy.at to AOL, but it doesn’t happen that often and works much less well in practice than in theory.

The second tendency of people with an operating background is to over-estimate how much the partners and staff in a fund can help at high impact moments, often compensating for weaknesses in their portfolio companies.  Examples are covering for partnership weaknesses by stepping in to negotiate key deals and unlocking value by turning the company’s focus onto a different market.  Good investors can and should add value in exactly this manner, but the first objective is always to back companies that don’t need this kind of help.  Moreover, helping like this is time consuming for partners and doesn’t scale very well. 

There has been a trend in recent years for venture funds to take staff on their own payroll and have them offer services for free to their portfolio companies.  Andreessen-Horowitz stand out as one of the leading proponents of this model.  For the funds whose fee structure allows it I think this is a great development.  However, the services offered are recruitment, corporate finance and the like – all services that the startup would be able to get elsewhere if they were prepared to pay.  This type of help is great in that it saves the portfolio company money and also saves them from having to spend time finding their own suppliers, but it is different to the sort of high impact strategic help that operating people often aspire to give.

As I said earlier a good VC adds value by offering help, but neither expecting, or insisting that it necessarily be taken.  Doing this well requires a deep empathy with the CEO and this is sometimes the hardest thing to achieve.  But with deep empathy the VC can get a sense of the help that is wanted, build consensus and channel his energies more effectively.  Sometimes this means the VC not focusing on what may seem to him (or his partners) like the most burning problem, but that’s ok.  Offering help that isn’t wanted isn’t the same as adding value.  Empathy, however, isn’t much use unless it is accompanies by good business sense, good judgement and practical advice, and good VCs add value by exercising the first two items on this list and offering the third.  Finally, value is added commonly added by well thought through introductions.  Note the caveat ‘well thought through’.  Making lots of introductions that suck up time but don’t go anywhere doesn’t help anyone.

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  • I wonder if you heard about the 2002 study “The Venture Capital Keiretsu Effect” by Laura Lindsey from Stanford. She claims that “by examining joint ventures and strategic alliances among venture capital portfolio firms,
    this paper examines whether venture capitalists facilitate collaborations within the
    portfolio. Using a large database of strategic alliances and financing information from
    Venture Economics, I find evidence of a keiretsu effect…”
    Samwer’s Rocket Internet seems to be applying the same method as A16Z–with great success. I wonder what you mean by hinting on the fee structure, though. Would you mind explaining that?
    However, I am
    starting to wonder what your perspectives are on a good background. Just looking at the usual suspects in recruitment for VCs in London, one might tend to believe that it is banking or consulting? Seriously, is extensive knowledge in PowerPoint really more helpful than operating experience?

  • Hi – Many of the best VCs have an operating background, and I think a good partnership should have a balance of operating and financial/consulting types. I have been thinking since I wrote the post that I should have been clearer on this point. So I think we might be in agreement there, or at least not too far off ☺
    I haven’t seen that study – so I will take a look. Thanks.

    Rocket Internet is a little different from a venture portfolio. They certainly have an operating model that makes sense, but I think it probably only works in ventures where they have effective control of the company – something most VCs get only rarely. My fee structure point is that unless you have a large fund – getting on for $1bn – then by the time you have paid enough associates and partners to invest the cash there isn’t much left to pay people dedicated to providing services to the portfolio.