A VC explains the one thing you should know about VCs: their Investment Thesis with Rory O'Driscoll (Scale Venture Partners)
What do VCs look for? It’s not uncommon in Silicon Valley to see equally smart firms, equipped with the same information, picking very different outcomes: from passing on a deal, to offering a wide range of term sheets. Often, these differences simply come down to each venture firm’s investment thesis — the internal rules that guide the partnership’s investment decisions. We talk with Rory O’Driscoll about what components can make up a VC’s investment thesis, how Scale Venture Partners shaped its own, and why it’s one of the most important things you should know when talking to a VC.
Do all VCs have an Investment Thesis?
Tim Anglade, Executive-in-Residence at Scale Venture Partners: We’re here to talk about investment thesis. I think it’s something I’ve heard a lot. Didn’t really quite understand what it meant until I worked a little bit inside of a VC firm. It seemed like every VC shop has one. It’s what guides their philosophy in investing. It seems there’s a lot of different parameters about that. What I love about Scale is that we seem to have a very well defined one as far as I can tell compared to other VC I’ve worked with, it seems to be very well defined along three or four different axis that I can detect.
Rory O’Driscoll, Partner at Scale Venture Partners: First of all I think you are right about every firm. Any good investment firm, in my view, will invariably have an internal language that they use to communicate with each other about possible investments with some degree of precision, but obviously if you’re running bonds it’s a totally different language, but you have to have that. It’s an indication that you though about the thing enough to have a fairly precise and fine-grained sense of what you’re looking for. Yeah, that’s true of any investment shop.
Tim: But you see some firms that have a very wide investment thesis. They do a lot of different bets on a lot of different things.
Rory: But that is the, the language of the investment thesis will encompass that. We are deliberately and consciously deciding to not put a lot of barriers on ourselves, we just do this. That could be the statement. We believe it comes from… Our referendum are come from a belief statement. We believe that we get the best results when we don’t encumber people with process or discipline. Whatever it is, it has to have a shared philosophy. What’s really hard in any partnership is if you don’t have a shared philosophy and different people are doing different things, if one person is making, trying to hit singles and doubles, and the other person is hitting home runs, then one of the other, those two people would be pissed off with the other. If the home run guy hits he’ll be like “I’m making all the money here” and if he misses, the singles and doubles guy is saying “I’m carrying this guy again”. It doesn’t work so you have to have a common language.
Investment Thesis Dimension 1:
What Stage or Risk Profile the VC Looks For
Tim: The first thing we seem to be very disciplined about is the stage we invest in. From an entrepreneur standpoint I might see that as like some people do seed, some people do growth, some people do late stage, and Scale has a very clear sense of the window they should invest in.
Rory: For Scale, you’re exactly right. We invest in, if you think of the continuum from early to late, we invest precisely in the middle. What we’re looking for is early product market fit. We’re no longer taking product risk but we like to take a lot of business risk. We like to take execution and scaling risk. The typical scale deal is doing one or two million dollars in trailing revenue. It’s acquired from early customers, typically the CEO’s, the salesperson, maybe one or two reps. You’ve got that early customer traction, but you’re a long way from a predictable, repeatable scalable model, and that’s what we underwrite getting to.
Tim: So it’s not even about the size of the check you write or the position you take. Sometimes I’ve heard that be a factor. It’s really just about the risk profile…
Rory: Totally. I think so some extent, you don’t want to do a two million dollar runway deal for 2% ownership because you’re gonna put in a lot of work if you’re committed to your companies and you’re not gonna get paid for it. We do want to get meaningful ownership targets, but we start first and foremost with stage. I always stay stage is the proxy word for risk. It really is. What kind of risk do you underwrite is another way of saying what are you competent in understanding? Early stage investors are fundamentally underwriting product risk and frankly, to some extent, team risk. Mid-stage investors are underwriting good market execution risk, sales and marketing execution, and late stage investors are usually underwriting evaluation risk, whether they know it or not. The company works, it’s clearly worth a lot of money, is it worth more or less than you pay for it? If you look at the failure modes of each of those three stages, it goes to failure to underwrite, understand that risk correctly. We’re all about understanding business risk, but good market execution risk, because that’s where the dollars go.
Investment Thesis Dimension 2:
The Specifics the VC Evaluates You For
Tim: And that makes sense. I see that also guides other thing that makes up the investment thesis, which is how you evaluate companies that apply. We talked about this a little bit with Dale and Susan in other videos, but how does that work for you? How do you think that your investment thesis guides you to evaluate companies one way or another?
Rory: Sure, I think we always say we’re looking for two things. It’s big picture trends and near-end traction. The big picture trends is a way of saying we have to believe this can become a big company. There’s simply no point in investing in a two million dollar company that can grow 15% year on year. It will never matter. You’re investing in companies that are going to become 100 million dollars plus in revenue base case, so you gotta have the big trends that are going to push it from two to a hundred. 50 X growth. That’s the first thing you have to have, which is big picture, long-term trends pushing in your favor. The second one is almost the opposite of that, near-end traction. What we’re saying is if you’re an early stage investor, you’re looking for the big picture trends that are going to happen in the future, but we’re looking for the big picture trends that are happening right now, and the way you see that is actual traction. You see customer’s buying, you see customers getting excited, you see renewals, you see some evidence that the market is saying now is the time where you can get it. Big picture trends and near-end traction.
Tim: It seems like you also look a lot at that ability to execute–
Rory: Well I was going to say exactly that because someone always says the way off is between management and market. The reality is, practically speaking, near-end execution, near-end traction is a proxy for management. How well are they executing, if the market is here, the time is now, how well are they executing? It’s not a perfect guide because frequently we’re backing first on entrepreneurs. At various stages in my career as an investor, I’ve had at various times some of the youngest publicly held CEO’s or CEO/CFO teams on the Nasdaq or on the NYFC so we’re backing people in their first job. It’s not always enough to say I’m going to check the manager with experience. How do you calibrate a first-time CEO? Yes, you can try and calibrate the intangibles, do I like him, do I think he’s a winner, but you know what I’ve learned? That companies that execute well in the near term on average continue to execute, and companies that let you down on the near term let you down forever. I really calibrate off these teams’ execution. That near-end traction, do they do what they say they’ll do? Do they get the growth they say they will? Do they understand their business? That to me is the best proxy. It’s the only proxy you have of whether a 200 million revenue company can go all the way.
Investment Thesis Dimension 3:
How the VC Manages their Investment
Tim: Right, that makes sense. I guess that also says a little bit about the next part of the investment thesis, which is how do you manage the investment once you’ve made it? It seems like some VCs try to be relatively hands off although that’s rare these days and people have different ways in which they like to partner and add value so to speak, with their investment once they’ve made the play. How do you think about that for Scale, for example?
Rory: Sure, and I’ve blogged about this. I have a very, I won’t say rigid but I have a very clear of what I’m gonna do and what I’m gonna help with and what I’m actually gonna do. What is the job of Venture board member? It’s an odd job, I always tell the CEO because the CEO will ask this. What’s your value at other than money? It depends on how cynical I’m feeling that day. First of all I often start with the money has a lot of value too, let’s not start with that. That’s just me being difficult, but what I really then say is this. I ask them what are you looking for in a Venture board member and what should you be looking for? What I say to them is “I have four jobs “as a Venture board member”. The definition of a job is if you don’t do it, it doesn’t get done. It’s not an assist. Helping with introductions is something I wanna do but it’s not my job. The fourth things I always tell my CEO’s, first, I’m going to be able to have a partial vote as a board member in hiring and firing and compensating you. The first question is hiring and firing your board member, your CEO, that’s a big decision. You should understand, Mr. CEO, how I approach that. When I want to back you, when I want to replace you, how I would handle that situation. That’s the big job. The second big job that the board member does is finance the company. Obviously when you’re doing the new deal, you’re financing the company. The real question for you as a CEO is will this investor be there when times are hard? Will he write a check when not everyone is willing to write a check? Does he have the gumption to support the company when times are tough? That’s the second thing you’ve got to calibrate with a Venture investor. The third thing, and it’s very obvious is, agreement on the broad strategic direction. I always say broad strategic direction. What you don’t want is someone to get in the weeds of your go-to market execution, unless they’re some kind of functional expert, but the typical VC after five years in the Venture business is a functional expert in nothing. Everything they knew is now five or 10 years old. I have to agree with the broad strategic direction. If the CEO is building a B2B play and I want it to be a consumer company, those would be the kind of things you need to hash out. If the CEO thinks this product applies best to the enterprise and I want to do an S&B play, and if the CEO thinks now is the time to execute aggressively, and I think now is the time to be circumspect, those are the kind of strategic alignments you have to hash out in advance. Then the last thing you have to do as a board member is elect when to sell the company and when not to sell the company. Both of those in different ways can be a hard decision. If you step back, those are four big jobs, all of which a board member has to do under U.S. corporate law, none of which the board member can effectively delegate to anyone else. What I always say to my CEO’s is this, I can give you a whole bunch of value ad schtick on top of that, but if you hire two or three Venture board members who do that job well, you’re halfway home. If you take on board some investors who don’t do that job well, then no matter how many good introductions they made, you could well be screwed. They might terminate you for silly reasons. To take the other extreme, they might not say to you “We need a better CEO” and that might just devalue your investment, and both have happened. I’m sure the first CEO of Ebay is pretty happy that they hired Meg Whitman and he made five or 10 billion dollars. It’s not a bad outcome. I’m equally sure that the guys at Google are really happy they took, and the guys at Amazon, Jeff Bezos and Amazon took it all the way. It’s never an obvious decision, which is why being very careful about the people that you are allowing have a vote in making that decision is so important.
Investment Thesis Dimension 4:
The Domains the VC Invests In
Tim: That makes complete sense. The last thing, and maybe to finish quickly, is this idea of where you do your investments. I think maybe Scale’s a bit more narrow in this than the average company, but I’ve heard a really well thought out reasoning for that. Maybe we can talk about that.
Rory: Well I said we focus primarily on Enterprise software. By Enterprise, I hate the word, because intents implied, big company, we focus on B2B software. Software being sold to businesses to either help them grow revenue or to help them cut expenses, and to be more efficient and to deliver customer delight. Sometimes because of that we get the look through to the end consumer, because what you’re seeing more and more is many of the success of the software companies selling to these B2B businesses is in large part a function of how successful they are in selling to their consumers. You see Demandbase, which is not a Scale company but we looked at it foolishly and didn’t do it, and they get paid in a percentage of GMV. Their customers are the retailers but you’re effectively betting on their success to touch that consumer trend, but we fundamentally invest in businesses, software companies and technology companies that are selling to businesses to help them exceed.
Tim: And why do you do that?
Rory: You gotta pick something you’re good at. It’s just that simple. I think that the ability to do all things is given to very few of us. I think there are about two thirds of the number of wins above a billion dollars or above 100 million dollars in the entire Venture Technologies stack come from enterprise software. As I’m sure you realized, the one third that come from consumer, 10 to an average, there were less of them but they tend to be larger because consumer tends to be a winner-takes-all, while enterprise software tends to be more of an oligopoly, there’s two or three winners. Over the last 10 years, roughly 130 exits above a billion dollars and roughly two thirds of them are enterprise software and roughly one third of them are consumer, with sub %10 being everything else in the noise. We think there’s a lot of opportunity there. We can be successful there, it’s what we know, it’s what we’re good at.
Tim: That makes a lot of sense. Thank you so much.
Rory: You’re welcome.
Originally published May 22, 2017.