[I'm speaking at the Asian Venture Capital Journal event here in Mumbai later today and these are the speaker notes I'll be using for my talk. The audience is primarily LPs which is a fancy way of saying that they're the people that give investors like me money.]
Today, we’re supposed to be talking about mitigating investment risk. Here’s the problem though: risk, as defined by economist Frank Knight in 1921, is something you can put a price on. In other words, to know the risk of something is to know the odds of something. If you know the odds of something, you can plan ahead for it. As investors (or professional gamblers), you can build it into your models.
With that definition in mind, what we’re really talking about here today is mitigating uncertainty which is risk that is hard to measure. Particularly in India, the uncertainty (or fear) from investors is that the founders may have demons lurking in the closet. Mitigating uncertainty, in India especially, is about discovering the “unknown unknowns” behind the founders or anyone else involved.
We should recognize that risk and uncertainty are fundamentally different. More importantly, we need to start building that risk and uncertainty into our models. We need to approach Venture Capital as a startup. We need to innovate.
Quoting Nate Silver, who correctly predicted the outcome of the recent US Presidential election in all fifty states, “risk greases the wheels of a free-market economy; uncertainty grinds them to a halt.”
We, as an industry, need to admit that we have a prediction problem. We love to predict things—and we aren’t very good at it.
What disappoints me is that we expect the founders we fund to innovate. Yet we choose to stay the same. We choose to continue doing business the same way as the VCs that came before us. That’s a shame.
The big opportunity in Venture Capital is to start thinking of ourselves as the card counters at the casino. Rather than the casual gamblers that randomly play tables and hands at the casino.
The good news is that most of the risk we see in early stage tech today is reasonably well understood. Most of the uncertainty can be removed by creating better systems and processes to assess incoming deal flow.
As we’ve all advised founders at one point or another, we look for warm introductions and we generally discard cold introductions. That’s one way we’ve already started reducing risk and uncertainty.
We’re increasingly moving to a co-investment model, we’re reducing the risk to ourselves.
More recently, we’re starting to request introductions to founders on AngelList. We’re friending them on Facebook. We’re interacting with them on Twitter. We’re engaging with them through their blogs. The point is that much of what we need to know about a founder is increasingly available and visible online. We’re doing all that to further reduce the uncertainty.
The market for private companies is especially vulnerable to the ideas of fear and greed. As an investor’s fears increase, her greed decreases. As her greed increases, her fears decrease. Economists might say that the relationship between fear and greed is an example of negative feedback. (The relationship between supply and demand is another example of negative feedback.)
The bad news is that we’re humans. We’re herd animals. As much as we hate to admit it, we look to other investors to get a sense for how we should feel. And this is where many investors begin to make bad decisions. This is where investors begin to lose money. Usually hand over hand. (As an aside, I believe committee-based decision making is one of the leading reasons why venture capital has been so good at losing money.)
The silver lining in all this is that there’s an arbitrage opportunity that exists for investors that are willing to think innovatively. In fact, that’s why a firm like 500 is able to exist — we’re here because there’s a gap between what early stage tech companies need and what early stage investors are currently doing.
To be clear, I’m not suggesting that what we’re doing at 500 is the “right way” to invest. Rather, my hope is that you’ll see that we have a thesis that we’re executing upon at 500. More importantly, my hope is that I might inspire you to consider whether you (or the funds you invest in) have a thesis as well.
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