A Peek Into the Mind of a VC

Date:   Friday , April 29, 2011

Every great investment has two components in common: a great idea, supported by a great team. The first thing we look for: an entrepreneur who has an idea that will transform existing markets, or create new ones. Beyond that, we want entrepreneurs who are willing to embrace the contradictions necessary to turn that great idea into a great business – persistent yet patient, knowledgeable yet willing to learn from the market, firm in conviction, yet flexible. An entrepreneur like that who can build a team will immediately get our interest. We look for entrepreneurs like that, whose teams are focused on a new market, or a market opportunity that is at least a few hundred million dollars in size, or ideally even billions of dollars in size. We then look for business plans which have compelling financials. Rapid, capital-efficient revenue growth and high gross margins are a great foundation upon which to build a long term standalone company. Finally, we look for high barriers to entry, something that will keep competitors at bay for as long as possible, and continue to offer an advantage over the competition when competitors ultimately do appear.

Should investments be sector based?
If you’re looking for out-of-the-box ideas, it helps not to box your thinking into sectors. So a specific sector is not an important criterion for us to invest. Beyond that, it is not uncommon for a company to change sectors as it evolves. What was a hardware company sometimes becomes a software company, or an IT company could be thought of as a CleanTech company in a few years. I have made investments in a wide variety of sectors including cleantech, hardware, software, consumer, and others. Sectors come in and out of vogue, and it is not always obvious if this sector is in favor permanently or if it is just being positioned as such. So that brings us back to the fundamentals of the company. Still, given that people see our work in sectors, I will say that right now we are seeing a lot of activity in the consumer space, cloud infrastructure space, mobile, cleantech, virtualization, and security.

A VC’s dilemma
At Foundation Capital, we usually invest for the long term. It is not unusual for us to be invested in a company for five or ten years, or even longer. So the fact that the stock market is up today or the fact that one quarter may have been a strong one is actually irrelevant to the way we evaluate an investment decision.

This sometimes creates a dilemma; because right now the economy is improving an we are seeing a lot of activity in some sectors. In a strong economy, entrepreneurs’ expectations for valuation are sometimes unreasonable. So there may be a gap between our position and the entrepreneur’s expectation. It is often the case that in a favorable environment such as the current one, people will expect a higher valuation, a change from the tough environment we had a few years ago. Even though it can cause tension, we stand behind our more neutral view of the world; which is focused on the long term.

A VC’s take
Focus on building a long term business that is profitable, and everything else should align itself behind that. Think carefully about anything that does not seem aligned with that goal.

Every entrepreneur will have certain expectations from a VC. I always say that entrepreneurs should approach a VC with the same mindset we have when we approach an entrepreneur. This means asking if this is someone you want to partner with for a long period of time to build your business?

Do not have a transaction oriented view of an investment but rather a partnership oriented view of how together you can build a business. Let that perspective guide your approach towards the specifics of your interactions; how you evaluate terms sheets, how you reach agreement on a valuation, and how you plan who should be on your board.

Common mistakes that young entrepreneurs tend to make
The most common mistake is not having a clear and deep understanding of who the customer really is and why they would buy your product. Great entrepreneurs usually have an instinct for what their customers want, and which is a good way to start. However, that is just the start. The reality is that there should be a lot more learning that must occur for a company to be successful, and that learning must be ongoing. I encourage entrepreneurs to personally visit and talk with actual people who have paid for their product. Entrepreneurs need to understand why customers bought what they were selling, how much they paid, whom they bought it through, and what are they going to do with it. Having a deep understanding of these are critical to the success of building a company.

Entrepreneurs have so many things to do when they are building a company and it is easy to get enamored with a product or idea, and distracted from understanding the customer. However, this should be the highest priority.

Author is the General Partner of Foundation Capital