Venture is an industry of exceptionalism

Sarah Lacy has an interesting article up on PandoDaily this morning about the data on the venture industry. The difficulty we face is that because the bulk of returns reside in a small number of companies and investment firms the averages aren’t a useful way of understanding anything. There is nothing new about this insight, but what I haven’t seen before is anyone taking the next step of working out what this means for people who want to play in this game. The money quote in the article is from Mike Maples (a successful Valley based micro VC):

My view of the tech industry is that it is an industry of exceptionalism. Period. The end.

Because the averages don’t mean anything it isn’t that useful to think about the market overall. Rather it makes sense to seek out the people and firms that can deliver exceptional returns.

One way that investors in venture capital funds have been doing that for decades is to back funds that have previously been exceptional. That isn’t a bad approach, but it fails to find any new funds that will be successful (like Mike’s fund Floodgate Capital for example) and it fails to spot funds that are going off the boil.

The better, but harder, way is to identify exceptional opportunities, as determined by the people involved, by the market opportunity they are chasing and increasingly by the product they are offering to entrepreneurs. This methodology could have predicted the success of Y Combinator. Investors who believed in Paul Graham, could see that the cost of innovation was falling, and thought the accelerator model made sense could have ridden that wave from the beginning whilst the traditional approach of backing proven teams with proven models wouldn’t even consider it.

The same methodology would also yield a better understanding of the current opportunity in European venture which is exceptional due to the lack of capital in the market compared with the volume of quality investment opportunities.