The Poker Analogy
A number of people have been urging me to blog more about the ins and outs of the VC business. My friend Gordon, in particular, suggested I blog this particular analogy, so here goes.
A lot of people think that venture capital is the most risky form of investing there is. Certainly the failure rates are higher than any other form of investing I know of. But I believe that venture capital is much less risky than people realize. And that's becuase we have the opportunity to scale into our investments, to "dollar cost average".
Poker is an incredible game. It is about risk management and knowing when to go for it and when not to. So is the VC business.
Early stage venture capital is a lot like poker. The first round is the ante. I think keeping the ante as low as possible is a good thing. I like to think of it as an option to play in the next round and to see the cards. Clearly, we don't ante up to just any deal, but it is very useful to think of the first round as the ante.
For the first year or 18 months, however long the first round lasts, you get to "see your cards". You learn a lot about your management team. You learn a lot about the market you've chosen to go after. You learn about the competition and a whole lot more.
Then you have to decide whether to you want to see "the flop", that is the next year to 18 months. The price to see that is usually higher. If you don't like your cards (ie your management team, your market, the competitive dynamic, etc) then you fold. Cut your losses. Preserve your capital. Wait for the next deal.
In poker folding is simple. In the VC business, it's not that simple. Sometimes you can fold by selling the company or the assets. Other times, you need to shut the business down. It's not easy and many inexperienced VCs make the mistake of playing the hand out because they don't want to face the pain of folding. That's a bad move.
If you structure your deals appopriately, you can often get three or four rounds. As your hand strengthens, the cards get better, you increase the betting, putting more money at risk in each subsequent round. That's how smart poker players win and its also how smart VCs win.
The poker analogy only works so far. Bluffing doesn't work in the VC business. If you've got a band hand, you really can't bluff your way out of it. But on the other hand, you can impact the cards you've got. You can work with management, beef it up, switch markets, buy some businesses, etc. You can significantly improve your hand if you work at it, something that's not really possible in poker.
That's why I think VC is mistakenly seen as risky. Sure the ante is very risky. But if you play your hands right, the subseqent rounds are much less so, and the fact that you can put most of your capital to work in the later rounds makes the total portfolio a much less risky proposition than the upfront ante.