Fear of The Living Dead in Venture Capital

It was not until I got into the VC business that I found out about the terrible, dreadful "living dead" - a term used to describe companies that merely survive, without future prospects. Normally fearless VCs fear the living dead. So do our LPs (the people who invest in VCs) who worry that we might waste our time (and their money) on a bunch of little companies that go nowhere.

Venture Capital is a "shoot for the moon" - go for the homeruns - business (for more on this topic see Swinging For the Fences). Most deals won't work out but great VCs bounce back quickly and easily. They focus on the winners and waste as little time as possible on the losers. When you think about it, the living dead might be far worse than the total losers because they continue to go on and on...potentially sucking up valuable time, energy and resources...indefinitely. Yikes! No wonder VCs fear the living dead!

The bigger you are (whether in size of wallet or ego) the more you will think that wasting time and money on little ideas and small deals is not worthwhile. For example, Larry Ellison believes that there will be only a handful of survivors in the software business - Oracle, Microsoft, SAP and IBM. To Larry, all others in the software business are as good as dead (or the living dead).

BUT, if you're really dead, then you have no chance.

In the VC business, all of our companies, even the very best, follow a rather bumpy and windy road. In the beginning, every company looks like a struggling little company with uncertain prospects.

The best approach to take in venture capital is to relish in uncertainty and to have a little humility.

There is no way to control outcomes in the start-up game. What you can control is whether or not you do your best and make sound decisions (like spending your time and money wisely) and just deal with problems (and take advantage of opportunities) as they come. If you stay hungry and learn along the way - and just manage to somehow survive - you give yourself a chance to make course corrections, take advantage of changes (often unexpected) in market conditions, or just get plain lucky once in a while.

So let's get back to basics...if you really want to have a chance at a homerun, you have to, first and foremost, make sure that your company survives.

Surprisingly, this is not obvious to some people.

One prominent LP once told me that he would rather have us return NOTHING than to play it safe. He was serious - dead serious. He wanted "volatility" because that's what is expected from the so called VC "asset class."

When I first heard this advice I was a bit shocked!

At Altos, rather than worrying about the dead, the living dead or the homeruns, we focus our early stage companies on getting to 1st base - typically around $10mm in revenues - without burning through a lot of capital.

If we can get to 1st base, then we might start to believe that there could be an interesting business forming. In our experience, most companies don't even make it that far, especially if people get obsessed with creating the next BIG whatever.

After reaching 1st base, some companies might go out of business (the equivalent of getting tagged out at 1st), or get bought out, or start slowing down. Only a minority of the companies that make it to $10mm, make it to 2nd base, or $40mm in revenues. At that level, we start to be fairly certain that we will have a winner...but we still don't know whether or not we have a homerun.

At this stage, some more companies might get acquired and others will start flattening out in growth (start-ups rarely go out of business at this stage but, as in baseball, you CAN get tagged out from 2nd base). Again, only a minority of companies break through to the next level...this time to 3rd base, or $100mm in revenues.

Once 3rd base is reached, VCs will typically get a 10x return on investment (sometimes 100x-1,000x, depending on market froth/timing). By that time, we also know that management is competent, scrappy and adaptable, through multiple iterations of products, strategies, business models.

By the time a company gets to 3rd base, at least 5 years (sometimes 10+ years) have passed. In the technology industry, that's an awfully long time! Whether or not a $100mm company can become a much larger company depends on countless factors that are largely unknowable at the time of investment.

We will submit that there is no way to know - a priori - which company will turn out to be a homerun at the time a company starts out (or when VCs invest).

Here is a thought experiment.

If you were really great at predicting the homeruns (and the losers), what would happen if you abandoned the VC business and started a hedge fund? If you can predict the winners and losers when companies have insignificant revenue streams, then you should be even better at predicting when companies reach $100mm (around the time of an IPO). Hedge fund managers can invest tens or even hundreds of millions of dollars at a time - buying or shorting public companies.

If you had invested in companies such as Oracle, Microsoft, SAP, Dell, Cisco and dozens of other companies shortly after their stocks were publicly available, you could have made 100x or more on each deal. So why waste time investing single digit millions in puny little companies?

As VCs, we love investing in tiny little companies started by passionate founders in interesting, dynamic markets. They always start as small, obscure, insignificant little companies that struggle along the way. The path is NEVER smooth!

It is a fact that most VC backed companies won't even make it to 1st base let alone home plate. But if we build solid businesses, based on sound fundamentals, we've seen that some do break through...to 1st, then 2nd, then 3rd, before reaching for home. We just don't know which ones will break through, often for many years after we invest.

We have ten year funds because it takes time as well as a great deal of hard work and suffering, enduring the ups and downs that come along for each and every company as they grow.

But hey, I'm not complaining about all that suffering (didn't Buddha say that "life is suffering"?). We actually love the bumps and bruises we get along the way. Some might say it builds character. But that's not the real truth. To actually LOVE IT, I'd say that great entrepreneurs, as well as VCs, are a bit quirky (some might even say that they are mentally imbalanced).

Rational or not, it has taken me a while to get over my fears...I fear not, the living dead.