VC Cliche of the Week

You work on something for months.

You get emotionally involved.

You really want to make the investment.

But you can't get the price and terms you want.

What do you do?

You Walk Away.

Walking away from a deal is one of the hardest things to do as a VC.

They teach you in business school that you should never consider the "sunk costs" when making a business decision.

But emotionally that's impossible to do.  If you've put hundreds of hours into something, you naturally want to see it to its conclusion.

But you have to have discipline in business.

You have to draw a line, really any line will do, that you won't cross.

Sometimes that line will be drawn in the wrong place.

And you'll miss something you shouldn't have missed.

But the discipline of having a target price that you'll pay is important.

You can't just keep raising it because that's what it takes to get the deal.

Because eventually you'll be paying prices that don't make sense.

I've said this before and I'll say it again.

Price matters.  If you can't make a deal in your price range, walk away.

Comments

[Denis de Bernardy]

> They teach you in business school that you should never consider the "sunk costs" when making a business decision.

A good trick to avoid blind consistency indeed. It is the hobgoblin of the little mind, as a psychologist once put it.

Personally, I generally encourage to 'think with your stomach', which is another way to say 'trust your body'. When a situation 'feels wrong', your body generally knows a few instants before your mind rationalizes and dismisses (to achieve a consistent behavior). Noticing this typically makes the difference between a good and a bad decision.

Out of curiosity: Did you 'feel' it was going to turn wrong long before it happened? As in, during the first few hours of work on the project on had a weird doubt. And then, you dismissed it, perhaps several times, out of sheer denial. Until it was too obvious to deny any longer.

This kind of escalation trap is as typical as it is common. And trusting your body enables you to avoid many of them.

[Dan Malven]

Fred,
I generally agree, but not always. There are times in the venture business when an opportunity is such a potential rocket ship that it makes sense to bite the bullet and pay a much higher price than you're comfortable with. I look at the work we did together on Sina. We made a good return on that upon liquidation, and during its life as a public company if we held on to the stock it would be a solid 10X+ gainer in 4 - 5 year period. But if we did not have to pay a bubble-era entry price for it, it would have been a 50 - 100X gain. Consider the numbers: we invested in spring 1999 when it had just done 1mm in LTM revenue. In 2004 it did 200mm in rev and 66mm in gaap net income. A 200X increase in revenue with 33% net margins should yield at least a 100X gain. But competition on the entry price made us pay a lot more than we would have liked, yet it was still a good deal.

Hunting elephants in the venture business is really hard. But bagging one or two elephants per fund is what drives portfolio returns. The small number of bagged elephants in the venture portfolios industry-wide are what makes the venture asset class a 20%+ IRR versus the 10%-ish from public stocks. I'm speculating, but I bet that if you took the top gaining 1% of companies out of venture portfolios industry-wide, the venture class IRR would drop to public stock levels. But, its the potential elephants that almost always seem to be priced too high during due diligence, and may get kicked out based on pricing discipline. The trick is having a better perspective than the next VC on what is truly a potential elephant and what isn't...and then keeping a good portfolio balance of potential elephants mixed in with deer, water buffalos and even the occassional plump squirrel that still gives a decent IRR.

The quote that I think of when looking at potential elephants is attributed to Don Valentine: "I like opportunities that are addressing markets so big that even the mgmt team can't get in its way." I know this sounds heretical given the usual VC mantra of "three things are important in the venture business: management, management and management" buuuutttt management teams can be augmented/replaced on the fly (difficult, but do-able; e.g. Sina had 4 CEO's in the 5 years post-investment), but sustainably competitive products and services meeting unmet needs in burgeoning mega markets can't be replaced in this era of fast-moving global competition with plenty of capital funding entrepreneurs all over the world all going after similar markets. The competition moves too fast for the so-called "A mgmt team with a B business plan" to re-orient to an A business plan and still generate a venture-class return for the investors who backed that B business plan. The company/mngt may do OK b/c they might re-cap to re-orient the business plan, but the capital that backed the B business plan craps out.

Pricing discipline abso-f*-lutely has a prominent place in the VCs toolbag. But I don't think its an absolute rule anymore; it is relative to the type of company you are looking at (i.e. elephant, deer or squirrel). I think this is just another consequence of the "flattening" of the world where economic and intellectual capital are zipping around the globe at breakneck speeds.

[sami]

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