As Published in The Deal, June 21, 2004
Breaking Point
By Richard J. Dumler, Milestone Venture Partners
All investors have their rules: Don't buy a stock that is going down; don't buy a stock with a price-earnings ratio higher than its growth rate; don't buy stock in an airline; and so on. And all investors inevitably break their rules — even Warren Buffett, as he famously did when he invested in US Airways Group Inc.
Venture capital investors also have their rules, of course: Invest only with experienced management; don't invest in a highly competitive market; don't invest in a business where the assets go home every night, such as consulting; and so forth. A venture capitalist's list of rules, in fact, should be very long. And venture capitalists invariably break these rules — regularly. In fact, the only rule they don't break is: Every time you do a deal, you break a rule.
In fact, Microsoft Corp., arguably the most successful venture investment in recent history, didn't have "experienced" management back in the early 1980s when Dave Marquardt became the only venture capitalist to invest in the company.
Since all rules have exceptions, I'm sure at least one deal contradicts the rule that every deal breaks a rule — that is, besides all the current deals enthusiastic investment bankers are trying to sell. I just don't know of any. Indeed, when the perfect deal does land on your desk, logically it has to break rules about valuation.
Looking at the investments in a current early-stage venture capital portfolio, each broke at least one internal rule, including all those listed above. Others broken included dictates against investing when there is a lack of momentum in sales, lack of control by the investor group, royalty arrangements with company founders. You get the idea.
None of this is to say rules can be broken with impunity. Nor is it in any way a justification for the ruleless excesses of the dot-com era. What you had then was less a matter of rule breaking than the creation of an alternate — some might say mirror — reality with "new rules," since the old ones were judged not to apply to the new economy. For example, "The more money you lose, the more valuable your business." With rules such as this, it's no mystery why an enormous amount of money was lost in the tech bubble.
Broken rules are generally labeled as risks. Using this terminology has a certain function of absolution about it in that risks are perceived as inescapable in venture capital — as indeed I have argued they are — whereas the concept of broken rules carries with it more than a little hint of irresponsibility. Viewing the process in terms of risk is good, because it forces you to carefully analyze what rules you are breaking and why. This in turn means extensive due diligence, ideally over an extended period of time. Break the wrong rules or too many on a given investment, and you will lose.
In this context, it would be truly wonderful if risk did equal reward, as we are constantly told it does. Why this is so remains a mystery to me. As any student who has dealt with the concept of expected value knows, it takes only a few low-probability risks to dramatically lower the expected value of an investment. Throw in just a 30% or 40% probability that something disastrous could happen, and you will almost certainly be out of the game before it ends, or you will have been incredibly lucky.
And this doesn't even account for the biggest risk, which is all the risks that haven't been thought about or otherwise taken into account. Inevitably, there will be surprises, a word with generally unfavorable connotations. Hence we get the often-stated preference for being lucky rather than smart.
If all the venture capitalist does is concentrate on abiding by his rules, he will make very few investments indeed. Some of the risks can be managed. For example, management can be replaced, though this entails risks of its own. Other risks can be endured; competitors may prove less than perfect themselves. But it is most essential to understand what the investment's compelling value proposition is and the fundamental — one might say almost inevitable — trend or force that is favorably altering the marketplace in which the company competes.
The assumption is that these exist. If they don't, these are most certainly two rules you do not want to break. The more compelling the value proposition is, and the more favorable the trend, the greater the tolerance for a few broken rules.
And there is one other rule that shouldn't ever be broken — though, as we saw with Enron Corp., it often is by people who should know better. And that is simply this: Don't do business with crooks, if for no other reason than you'll sleep better.
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