VC Due Diligence: The 3 Laws of Venture Capital

Continuing on my post about The VC Due Diligence Process, I wanted to expand on David Silver's "3 Laws of Venture Capital" here. Again, the three laws are:

1. Accept no more than two risks per investment
2. V = P x S x E, where V = valuation, P = problem size, S = solution elegance, and E = entrepreneurial team quality
3. Invest in big P companies, because the public market will accord to them unreasonably high V's, irrespective of S and E.

In more detail, here's each one:

1. Accept no more than two risks per investment

Silver outlines the five typical risks that start-ups or early stage companies face:

1. The Development Risk: Can we develop the product?
2. The Manufacturing Risk: If we can develop it, can we produce it?
3. The Marketing Risk: If we can make it, can we sell it?
4. The Management Risk: If we can sell it, can we sell it at a profit?
5. The Growth Risk: If we can manage the company, can we grow it?

The first two risks, Development and Manufacturing, need to be borne by the entrepreneur. VC's generally don't pursue companies lackingn a completely working product or service and if they do, they'll invest no more than 5% of their fund in them. The next two risks, Marketing and Management, are the acceptable risks that the venture capitalist is willing to take on because they are the most controllable and ones where the VC can bring their resources to bear. The Growth risk is normally uncontrollable because it often falls after an IPO. At that point, the VC has no control over the often erratic nature of the public markets.

For entrepreneurs looking for Development capital, typical sources include 1) wealthy individuals (angels), 2) state or federal grants, 3) customers, 4) suppliers, or 5) family and friends.

2. V = P x S x E

The second law of venture capital is to look for a combination of factors that will maximize a company's long-term ability to achieve high valuations. The components are the following:

• P = problem size
• S = solution elegance
• E = quality of entrepreneurial team

When evaluating investments, the VC can rate each factor on a scale, let's say 0 to 3, to result in a total possible score of 3 x 3 x 3 = 27. The objective to consistently invest in companies with high quantitative values.

P: The last law covers this in more detail, but VC's generally look for companies that have created solutions for very large problems. If VC's continually invest in large problems, it's much less likely that they will waste capital because the problem is small rather than large. It explains why VC's follow the "megatrends" in society. A few previous posts I've had allude to this, including Kleiner Perkins and Energy Investing (“I believe what we’re investing now is a pittance in comparison to the size of the opportunity and the size of the problem.” - John Doerr), Soros on America's Next Engine of Growth, and Biofuel Bubble.

S: The solution elegance is based on two components - S = B x T, where "T = the existence of low-priced technology and B = the business plan or the solution delivery mechanism". An elegant S means the solution is proprietary or has a non-duplicable distribution system. VC's consider patent protection or lead team when assessing the T compoment. The B component requires that a competent business plan is presented by the entrepreneur or that one is produced prior to the investment being made.

E: The VC has more control over changing the team than they do the solution or problem. However, there are typical characteristics that successful entpreneurs and manager partners have that a VC should look for. These will be expanded on in The Audit of E post, but I'll list out the criteria here for reference.

Characteristics of Successful Entrepreneurs

1. Age, Appearance, and Other Outward Signs
2. Origins Are Middle-Class Homes
3. The Absent Father
4. Entrepreneurs Are Usually Guilty
5. Entrepreneurs Were Deprived as Children
6. The Ability to Focus Intensively on a Single Subject for a Sustained Period of Time
7. Entrepreneurs Have Uncommon Courage
8. Entrepreneurs Are Creative
9. Entrepreneurs Have Insight
10. Entrepreneurs Are Happy and Good Communicators

Characteristics of Successful Manager Partners

1. Age, Appearance, and Other Outward Signs
2. Corporate Achiever
3. Dissatisfaction and Energy
4. Heart
5. Practicality, Thoroughness, Capacity for Work

3. Law of the Big-P

This law is that "In Big-P Companies, the valuation is equal to the size of the problem, rather than its solution". The typical public investor, apparently, loves a good chase and is willing to invest large amounts of capital in companies that are chasing big problems with elegant solutions. It's surprising, though, that once a company actually has earnings, that a solution is addressing the problem, it is no longer a big problem and valuations go down dramatically. VC's exit before this point.