Why do bad deals happen to good people?

Friday Jul 6, 2012 by Sarayu Srinivasan - Venture Capitalist

Every technology investment is made in the belief that this will be the big one. The deal that will produce not just a great return but a stark, raving, mad return with multiples that will break records. And hearts. The next Apple. The next Google. The next Facebook.

However, the majority of venture funded deals never make the super sized returns that give the VC industry its sexy reputation. In fact, its actually only a relatively small proportion of deals that produce those mind blowing returns. But the belief and hope is that those big returns are so spectacular that they make up for the rest of the portfolio (that may not be performing up to those lofty expectations.)

As a tech venture capitalist, I am often called on to opine on the topic of what technology investors, particularly angel, venture and growth investors, are looking for in a potential investment opportunity. That is, why they would invest in a particular idea or company; why they choose one opportunity over another. This topic also makes up the basis for one of the most frequent questions I am asked for advice on by entrepreneurs preparing to raise a capital or attract investors.

Usually, in the way of advice, I can suggest a number of items that may move the company down the road to being perceived as more attractive to investors. Things that a VC would want to see in order to consider investment. I need not exhaustively recount those characteristics here since they should be easy enough to identify if you have a computer and internet access, but I can list a few. They include addressing a large, growing market, generally in excess of $500MM; a solution to a pain point (the more painful and endemic the pain, the better) that is either at prototype or product v1 equivalent; a skilled or experienced management team; traction in the form of customers, contracts, revenues and/or the vertical’s metric du jour; and a competitive advantage or barrier to entry that will slow rivals. Generally, an investment partnership will be pleased to see the maximum number of these boxes checked off. And yet, over the years, I’ve repeatedly observed some interesting deal making behavior that doesn’t always follow the checking off those fundamentals described earlier. Its in one way quite surprising and in another not surprising at all. What I’ve observed is the following:

That’s it.

Not only does it seem simplistic but also incredulous. It rings false. How could these professionals with storied investing pedigrees, deep expertise, significant operational track records and strict analytical approaches to everything make decisions involving millions of dollars and the fates of entire companies based on emotion? They are metrics driven. They are rational. Their success depends on choosing the right horse to bet on; a horse selected through painstaking, careful diligence; focused research and analysis; a deep understanding of the environment and their drivers, and a finely calculated bet on skating to where the puck will eventually end up. There’s hardly room for sentimentality here.

And yet, emotion does play a role. A larger role than people want to admit. Many times, maybe always, investors hear a great story and are enchanted. Simplistically, they fall in love. They are taken with the entrepreneurs. They are spell bound by the industry potential. They find the product incredibly sexy. They want to be part of the history of bringing this great thing to market.  Something is triggered inside bonding him or her to the concept and on some level they become emotionally invested. To believe that investment decisions are made in the absence of emotion, that they are completely rational, data driven decisions is not just unrealistic, it is mostly untrue.

Investors fall in love the way we do in real life; intoxicated to such an extent that they sometimes wear blinders to that which may temper their passion.They compensate, consciously or unconsciously, for the drawbacks that must surely exist. No person is perfect and neither is any deal, but investors are expected to back those companies that have as few of those fatal flaws as possible to have the most chances of success in their field. Recent popular psychology suggests that we make judgements about people within minutes of first meeting them; could this be true with deals too? Not every deal, of course, is make or break in the first minutes, or is the result of a VC falling for the company, but the role of emotional drivers in the deal process is very valid.

Over the years,  I’ve firsthand witnessed this falling in love phenomenon with investors of all stages and ilk, all over the world. Sometimes its immediate, sometimes its in the course of the pitch, and sometimes its because of research and analysis (which is self generated or self selected). Data points will partially support the investment thesis but it there will also be a leap of faith, where one must believe in the concept, entrepreneurs, market, particularly at earlier stages of investing. And this faith, this belief that fills the chasm (that investors believe springs from objective analysis or prior experience) is rooted in emotion and hope.

This phenomenon of infatuation is neither anything new or limited to the venture investing world. Ben Graham, one of the most well known and best regarded professional stock investors and mentor to modern day investing luminaries like Warren Buffett, pointedly warned about the need for constant vigilance with emotions that could easily and unconsciously color an otherwise disciplined investment process. It is true that some respected investors invest, in part, by their instinct and intuition both honed over years of practicing their craft but also likely inborn, a sixth sense about people and opportunities. This intuition is different from falling for a good story because intuition is instinctual and automatic, perhaps anchored in past experience. One is seduced by the story where there may be signals indicating that this really isn't a great deal, just a great tale. This doesn’t mean that investors will invest without serious diligence or analysis but that there is a predisposition to fill the gaps that may come up while kicking the tires, that we cross t’s and dot I’s for the entrepreneurs because we so want this to work; there is a field of distortion.

I recently judged a business plan contest where I was the only female venture capitalist. One of the teams had a great story. They were young and inexperienced (they’d started the company in college) but they had strong educational backgrounds and a demonstrated track record of achievement. They were an all female team targeting an all female market.  Recently, several female led companies had received funding in high profile raises and so the time seemed just right. The company had generated nominal revenue “without really trying” (imagine what they could do if they tried!). They all had offers from top business schools and were deferring. They were polished, attractive and well put together. All together it was a compelling tale. They seemed poised to rocket to the stratosphere whatever they did. Success was predetermined. Except one thing: the core product was terrible. On near every dimension. I was personally disappointed as I had very much wanted to support the company but I would not be able to justify that this was  a good investment to myself (or my partnership). But I realized this was a sexy story and that that would appeal to someone; there were too many great ingredients. When the judges privately discussed the company later I predicted that they would not only go on to raise funding despite their sure to be dismal business prospects (if they continued in their current incarnation) but  would attract the attention of the top tier firms in the US. The last I heard, many months after the contest, the company had been able to get meetings with prominent US venture capital firms and from what I heard, were making some headway. I was less than surprised.

Sarayu Srinivasan is a venture capitalist and an advisor to venture and private equity firms in the US, India and Europe. She was most recently a Director at Intel Capital where she focused on sector agnostic venture capital and private equity investment into a range of stage agnostic technology businesses in the US, India and other regions.  You can follow Sarayu on Twitter (@sarayusalian) by clicking here.

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