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Building investor confidence

Venture capitalists are known for pestering their portfolio companies for endless data such as growth forecasts and detailed budgets. But what figures do venture firms have for their own performance? Daniel Lopez of IDG Ventures Europe argues that general partners could do more to foster increased confidence among their investor base.

Venture capital decision-making has always had an air of black magic about it.

When a firm chooses one company to invest in out of over 100 companies seen, the decision is going to be by its very nature a little arbitrary. Once the 100 prospects are narrowed to the ten truly credible opportunities, mental acrobatics can defend any one of the remaining candidates.

After being ruthlessly efficient in moving beyond the weaker 90, however, a venture capitalist builds a great deal of momentum and skill for finding weaknesses in a company's business model or prospects, and it is in fact very easy to become pessimistic about the remaining opportunities. There are always good reasons to believe a business will fail, but our jobs require that we see realistic paths to success. Making intrepid short-term decisions while thriving over the long term requires an interesting balance between science and religion… between reason and faith.

The religious aspect of venture capital is the major source of the industry's mystique; faith in their instincts imparts risk-seeking personalities with the strength to become the champions of unproven industries. First, a VC has to be the champion of the company within his or her own firm as the deal works its way through the investment committee approval process. After the investment, a committed VC has to turn his advocacy towards other VC firms, the press, and the world at large. Without faith, investors are lemmings - or worse - paralysed into inactivity.

During the good times, faith and courage may have been enough to be successful, but a dose of scientific rigor can vaccinate against the down cycles a long-term investor will inevitably experience.

Venture capitalists are known for pestering the companies they evaluate for reams of data, from market share analyses to growth forecasts to detailed budgets. But what hard metrics do venture firms have about their own performance and their own industry? A number of research firms make a business of collecting ROI data for the venture industry, but that kind of data is so long term that it is of minimal use for operational planning and assessment.

Like any other industry, venture capital firms compete in a market. One market is for money seeking investment opportunities, and venture firms are competing against many alternatives, including public stocks, property, bonds, and of course, other venture firms. Ultimately, the investors into venture funds are atheists and are only interested in the real ROI figures.

The other market venture firms compete in is the set of the hottest start-ups that will provide superior returns for their investors. Very few venture firms, however, have any real idea of how they're performing in this ‘dealflow market' relative to their peers.

One method could be to compare a list of companies that a firm considered investing in on a quarterly basis to the full list of all deals funded in its sector space and geography during the previous quarter, using venture databases such as VentureOne and Venturexpert. As a result, the firm could tell what percentage of fundings were known about beforehand, and thus what fraction it had the opportunity to participate in. We call this ratio the ‘market share.'

While a high market share is not automatically a positive indicator, it does give a sense of the extent and quality of connections with other firms and with the entrepreneurial community. It also provides reassurance that you have a finger on the pulse of the sector and know about what's hot before it appears in the venture newswires a few months later.

This kind of information is useful not only for self-assessment over time but also for demonstrating to a VC fund's investors that, despite a market slowdown, you're still ahead of the curve and learning lessons that will prove useful on the road ahead.

During these times when many venture funds are closing down or contracting, increased confidence from VC fund investors can make the difference between the VC going home and staying in the game until the tide turns around. And when it does, we can dust off our faith and start again with the well-grounded confidence of knowing the playing field inside and out.

Copyright © 2002 IDG Ventures Europe

Daniel Lopez is a principal at IDG Ventures Europe.

IDG Ventures Europe is a $100m London-based fund helping entrepreneurs grow innovative companies on a global basis. It is an independent partnership making investments on behalf of its limited partner, International Data Group, the world's largest IT media company. IDG currently has a $580m network of funds spanning Europe, North America and Asia that have invested in over 100 companies over the last ten years. For more information please visit www.idgve.com