Making Sense: What Keeps Venture Investors Up At Night

Entrepreneurs always wonder what is on the minds of investors scrutinizing their companies. Investors play coy because they dont want to be gamed. In the following essay, venture investor Roger Ehrenburg shares his thinking in HuffPost about not just the companies being considered, but the process by which investments are identified, vetted and selected:

"As a venture investor, one thought routinely keeps me up at night: Are we making the right investments?

After the beads of sweat form on my brow, they really get going when I think of the complexity and multi-dimensional nature of the question. Some related issues that keep me awake include: Are we seeing the right deals? Is our evaluation process effective? Does our method of decision-making promote successful outcomes? Are we capturing the data necessary to make a reasoned assessment of the above?

Gulp. Each one of these represents a key strategic initiative, core questions whose answers are necessary for building the best firm possible for the long term. Needless to say, these issues can't be assessed in a vacuum, as the vectors of time, competitive pressures and market conditions are at play and invariably impact the answers. In short, running a venture firm is very difficult, and it's successful operation involves navigating a multi-variate thicket of obstacles while optimizing the combination of long-term franchise value and LP returns.

Are we seeing the right deals?

One of the eternal questions in venture capital relates to the "deal funnel": Should we work to maximize throughput or optimize for quality. There are massive trade-offs between these two approaches, and different strategies subject themselves better to one or the other. For example, a general fund that is seeking to make a very large number of small investments is likely to solve for maximum throughput.

They will apply a very basic but robust screen to quickly weed out the definite "nos," likely do those that arrive with a high degree of "social proof" and spend some time thinking about the rest. Conversely, a more specialized fund (like IA Ventures) works to be crystal clear in its messaging in order to only attract deals that fundamentally fit with its investment thesis. This will yield a smaller amount of more highly-curated throughput, providing a more manageable pool of deals that require more in-depth screening before a go/no-go decision is arrived at.

Seems pretty rational, right? Well, if you consider being almost 100 percent reactive rational. The problem is, I don't. While having a giant catcher's mitt is a fine way to gain a sense of what's trending, it is very hard to identify true gems sitting on your ass and letting the market define your opportunity set. So that means thinking deeply about what the future holds, considering mega-trends, and actively seeking opportunities that others think suck or simply don't understand but really represent a window into the future.

It is quite difficult to have this level of conviction and risk tolerance and to subject yourself to ridicule by shunning conventional wisdom. But who said the road to innovation -- and riches -- was going to be easy? It's not. Being contrarian and pursuing true innovation requires a lot of hard work, and sitting in your office and simply being a filter is not the way to achieve extraordinary returns IMHO. So bottom line: our approach is to combine a clear domain focus (which generates curated, but reactive, deal flow) with a willingness to try, test and incubate.

Is our evaluation process effective?

The Big Screen. Not easy, when you consider the massive inbound volume of most venture firms (and IA Ventures is no exception.) Do we have a clear sense of what we're looking for (like a checklist), or is the spark of a crazy idea what really gets us going? More importantly, what should get us going? And are we able to glean enough from basic written materials to make an educated judgment as to whether or not an idea is worth digging into? Due to sheer volume, it is impossible for us to engage with more than a small percentage of the companies that reach out to us. Since we're almost exclusively focused on pre-revenue opportunities, it really is about the entrepreneur, the idea and the vision, not actual performance. And most challenging of all, we are too young to have much data on the efficacy of our evaluation process. We do not yet have an "anti-portfolio," a series of misses that might be instructive of our fears, biases and blind spots. So we are using our experience and best efforts to choose well, but with precious little data on which to base our decisions.

As a firm, we have a series of well-understood "hot buttons": a set of attributes we are looking for in an opportunity. These attributes are applied to the top of our deal funnel, sharply reducing the number of potential opportunities that warrant a follow-up phone call, meeting, etc.

We definitely try to apply the lens of "Is this really differentiated/transformational/addressing a sharp pain point in a large market?" when gauging our interest. We are also predisposed towards opportunities that reach us early in the financing process, where we can both play a significant role in the deal and work with the entrepreneur on the plan, milestones and syndicate. The nature of our interaction with the entrepreneur is also instructive of whether we make a good team, and a positive working relationship can help de-risk execution of the plan. While I feel like we're doing the right things, the jury is still out until we are able to collect the data necessary to validate our process.

Does our method of decision-making promote successful outcomes?

Now this is where it gets very tricky. Different partnerships have starkly different views on how a deal gets approved. They also have different cultures with respect to individual "check writers" versus a firm approach. Some firms want consensus. Others will not do a deal if there is consensus. Some firms have very rigid time frames around which funding decisions can get made. Others are more free-form.

How a firm makes decisions can define a culture and a partnership, and is not a matter to be taken lightly. At IA Ventures, we take a team-managed approach to investing. There are no individual check-writers. We invest as a group. We do not strive for consensus or have hard and fast "thumbs up/thumbs down" rules. Deal deliberations are active and ongoing at each stage of the evaluation process, and by the time we are considering issuing a term sheet, we've all hashed it out pretty well. It is rare that all four of us are equally pumped about a deal, which is good. Because if we're all psyched, it probably means the idea isn't sufficiently differentiated to disrupt a market. In fact, we revel in conflict and dissent because it forces us to look at all sides of an opportunity, and to guard against the group-think/rose-colored glasses associated with a "hot" (read: popular) idea. I think we do a pretty good job on this front.

One thing we don't do -- an idea that my smart friend Phin Barnes and I were kicking around last week -- is empower an individual to meet an entrepreneur, fall in love, have a strong gut feel and make a commitment on the spot. The benefits: a willingness to fund orthogonal ideas without over-thinking and detailed analysis; a forced focus on the entrepreneur and their power to make an idea come to life; a special bond with the entrepreneur by showing deep confidence and conviction in their idea by offering an immediate commitment; and the signaling effects of having a firm and culture that supports such instinctive and passionate decisions in favor of the entrepreneur. If one truly believes that success in stage investing is heavily dependent upon the quality and passion of the entrepreneur and a contrarian take on the market, then having this as part of an investment program might be both rational and effective. I'm not there yet, but it is certainly a provocative and interesting approach to deploying an amount of high risk, high return capital.

Are we capturing the data necessary to make a reasoned assessment of the above?

It is early days, but we have built instrumentation and processes to help us collect data on the dimensions discussed above. While there is little doubt in my mind that smart venture investing -- specifically seed stage investing -- is impacted by a heavy dose of art, with a modicum of science, we want to collect as much data as possible about how we do what we do to ensure that we're using all the information at our disposal. Are we seeing the deals we want to see, and what portion of the deals are because we went out and got them as opposed to them coming to us? Are we doing a good job investing in companies consistent with our mission, some of which are off the beaten path? Are we taking enough risk, and do members of our firm have the opportunity to be hard-core champions of a deal and to get it done in the face of dissent? Do our dashboards give us useful and actionable information about how we should be running our business? All of these metrics are important for doing the best job possible and building the best long-term business at IA Ventures, for the benefit of our entrepreneurs, our LPs and our firm colleagues.

Being a startup investing in startups is no easy task. But we're trying to be thoughtful about it, try new things and iterate rapidly with the benefit of data. Sounds a lot like what we expect from the startups we invest in. Makes sense.