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Venture innovation.

I’m not sure what the venture community makes of Right Side Capital Management, but I think their novel approach to early stage investing is really interesting:

Yes, we do love fledgling startups. They may not have finished products, marquis customers, or proven markets. But every one has “Black Swan” potential.

Given the opportunity they represent, seed-stage startups are badly underserved. The chances of finding funding are so low that many qualified entrepreneurs sit on the sidelines. It takes so long to put together a decent-sized angel round that many promising companies miss their market window. The transaction costs are so high that a good chunk of investment capital evaporates instantly.

We’re going to change that. We’re planning to fund 100-200 seed-stage startups each year and give founders a yes-no decision in two weeks. It’s a win-win. Lots of entrepreneurs get a chance to innovate. We get a well-diversified portfolio.

I think this approach is very clever and (in a slightly different context) in fact a couple years ago worked on a business model focused on improving angel funding process / environment (for both investors and entrepreneurs) that very much relied on a similar systemization of process. While I’m not sure we are ready for a fully algorithmic early stage investment process (black box VC anyone?), it seems clear that there is certainly a lot of room for a more robust (technology-enabled, data-driven) process, lowering costs and improving efficiency. I hope RSCM succeeds and in so doing helps move the market towards this vision which I think would be a win for both investors and entrepreneurs.

I particularly like the way they have clearly articulated one of the key factors involved in early stage investing – chance – and how their high-volume, process-driven approach addresses this issue head-on and seeks to mitigate the impact of luck (good or bad) on portfolio returns:

However, we also understand that the probability of a particular young startup succeeding is relatively small. Many things are beyond its control. Many things can change. Many things have to go right. Probability compounds and there are literally thousands of factors that can significantly affect a young startup. So there’s a tremendous amount of uncertainty. We do not believe anyone has a model with much skill in picking winners at the seed stage. Therefore, the only reasonable strategy is to diversify away the idiosyncratic risk as much as possible by constructing as large a portfolio as is practical.

No one can claim to ever be able to fully remove risk from any process, but by bringing talent and a deliberate process to bear, I do believe one can improve the odds of any given outcome considerably. A top professional golfer cannot guarantee a hole-in-one, and indeed it is possible that a 36 handicap weekend warrior could get one. Black swans etc. But if the competition consists of hitting 100 balls to a par 3 green and scoring 10,000 points for a hole in one, 100 points for any ball within 3 feet and 10 points for any ball on the green, I know I’d much rather back the professional golfer, even though there is a non-zero chance that the hacker could get lucky and win. I think venture – and especially early stage – investing is similar. I can’t guarantee any investor that I will get a hole-in-one. But I think I can make a credible case that most of the investments I make will be ‘on the green’ and a fair number will be ‘inside the leather.’ It seems that RSCM have taken this view and put it explicitly at the heart of their approach.

However, I would be curious as to the reaction of their potential investors/LPs to this kind of approach. It is entirely anecdotal and quite possibly an unrepresentative sample, but we have found most investors to be very cautious with respect to any new approach and/or structure, preferring standardized and ‘traditional’ ways of doing business with innovation a domain to be restricted to the companies we invest in. This of course may be particular to our circumstances, but given the extremely high homogeneity in fund structures and investing approaches we have observed across the venture capital (and private equity) universe, it would indeed seem that limited partners have little or no appetite for (as RSCM puts it) “innovation in the business of innovation.”

So if there are any LPs out there reading, I would encourage you to comment on both RSCM’s model specifically, and especially on innovation in fund structures and/or investment methodologies more generally.

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Kublax (RIP) Markets in everything, Part 471: Hooray for Hollywood
  • bernardlunn
    Sean, interesting thread. I have been thinking about something similar. I think it can work if one has a clear financial model. For example, if the focus was SaaS, you can build a financial model for that. If the model was gaming, I am sure one can do the same there as well (not that I understand gaming at all). Online ventures can only have revenue from 3 sources - ads, subs and trans - and all can be modeled. That way one has a way to evaluate and track on real metrics - a simple dashboard. The trick would be finding a way to get value from the ventures that get to cash flow profitability but a level of revenue that is normally below the exit parameters. Bernard
  • Chuck Farley
    (Hi Sean, I'm back from a blogging hiatus!)

    Shouldn't we be worried about how a broadly diversified, high- risk/return pool of capital spread across many seed projects benefits to the *fund's* investors? A VC fund makes its fees by providing the end investor with a skilled middle-man, one who adds value by advocating for a network a private entrepreneurs, and by making good investment picks within that network. Why should I pay VC fees, if they are just exposing my capital to macroeconomic risk? The more diversified a VC fund get, the weaker their raison d'etre.
  • Welcome back! Whatever the asset class, as an investor if I'm paying for active management, I don't want a passive, index-tracking portfolio. However, what RSCM is proposing - and what I think is clever - is not an early-stage 'index-tracker'. To create such a broadly diversified portfolio would entail investing in thousands of start-ups and I share your doubts as to whether or not this would generate interesting (any?) returns even before fees.

    What I think is intelligent in the RSCM approach is that by applying a rigourous process to early stage investing, they will select 100-200 start-ups (out of the universe of thousands) which should allow them to diversify away some of the randomness which is a structural reality of early stage investing. To use my analogy above, through their skill and process, they will look to put 100-200 balls on the green, giving them a better than average chance to make pars, birdies and even the odd hole-in-one...Of course, they will need to prove that their process does indeed act as a useful filter, but the principle is sound in my opinion.

    It is perhaps worth stating that I don't think this is the only or even best way to do early stage investing, but rather that I think it is a very interesting and potentially highly complementary (to the existing ecosystem) approach that intuitively makes a lot of sense. As I said in my post, I particularly like the fact that this approach explicitly recognizes and seeks to mitigate the element of chance or luck and the role it plays in investment returns when dealing with seed and very early stage companies. This intellectual candor definitely makes a good first impression.
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