Moneyball, Theo and VCs

I confess that I am a devout Red Sox fan.  The habit started in 1975 when I sat on my father’s lap and watched one of the greatest World Series of all time against the Big Red Machine (my second favorite team at the time).  The great tragedies of 1975, 1978, 1986 and 2003 are forever burned in my memory – as well as the great triumph of 2004.  Even my chosen blog photo is a bow to the Red Sox – a picture of me sitting in manager Terry Francona’s office at my beloved Fenway Park.

Therefore, I am a sucker for baseball-VC comparisons.  I have refrained from writing too much about my beloved Red Sox, but the departure of Theo and the recent blockbuster trade to acquire Josh Beckett, a pitcher recently heralded as the second coming of Roger Clemens, have awoken me from my self-imposed restraint.

The first comparison of note is applying the Moneyball theory to venture capital.  Written by Michael Lewis in 2003, Moneyball provides an inside look into how Oakland A’s General Manager Billy Beane constructs winning baseball teams with a constrained budget.  One of Beane’s secrets is to stay away from over-priced, super-stars.  Having put a number of strong years under their belt, a player on the “back nine” of their career may have the ability to earn a high price in the market, but may not be able to recreate the performance numbers going forward that would justify their inflated value.

One veteran VC friend of mine commented to me when Moneyball came out that he felt the same way about entrepreneurs.  VC firms like to brag about their habit of backing superstar, repeat entrepreneurs.  But my friend observed that the problem with superstar, repeat entrepreneurs is that they know they’re superstars.  Therefore, they command a high premium in cash, equity and deal price.  A typical series A of $4-6 million on a $4-6 million pre-money valuation might suddenly become $8-10 million on $10-15 million pre-money valuation if a superstar, repeat entrepreneur is at the helm.  Will the performance justify the inflated price?  Manny Ramirez has had a terrific five seasons in Boston, but the team keeps trying to unload his contract because they’ve concluded his great numbers simply aren’t worth the astronomically high price they pay for him.

Like top baseball scouts, VCs are better off looking for the lesser-known players who have superstar potential.  It’s easy to get into the hot deals with proven entrepreneurs if you “pay up”.  But who among us can spot the next David Ortiz, a player that languished for six years with the Twins, was signed for a relative pittance by the Red Sox, and has emerged as the game’s premier superstar, receiving the most votes for any player for the 2005 All-Star team?  At age 25, recently acquired Sox pitcher Josh Beckett could be the next Roger Clemens in terms of prospective performance – but he certainly won’t be paid anywhere near Roger’s $18 million 2005 salary.

If you subscribe to the Moneyball theory of VCs, you would be better off backing the young, hungry entrepreneurs who have something to prove – and are willing to make the financial and personal sacrifices to achieve a “win”, than the proven superstar entrepreneurs who command premiums.

Another interesting VC insight from baseball struck me a few weeks ago with the news of General Manager Theo Epstein’s departure.  The wunderkind general manager decided it was time to spread his wings and break out on his own.  Despite the great mentorship he received from CEO Larry Lucchino, Theo decided his own interests were no longer aligned with the rest of his “partnership”.  Sound familiar?  How many stories have we been reading about the young guys in VC firms breaking out on their own (with my own firm reflecting this general characterization), never mind other private equity shops and hedge funds?  No longer satisfied with the status quo of marching to someone else’s beat, young talented executives are often compelled to make their own way in the world and build their own legacies.  Although I am saddened by Theo’s departure, I acknowledge that this is simply the way of the world, and know that my own industry sees this behavior quite frequently as well.

There are many other amusing analogies – VCs combing the landscape like a good scout looking for undervalued opportunities/players, VCs behaving much like the most callous GMs when they treat entrepreneurs like pawns in a chess game – that are worth further exploration.  But I will now return to more business-like analogies rather than allow my blog posts to further reflect my Red Sox obsession!

The Inside Out – Outside In Dance

When an entrepreneur has taken VC money in a first round of financing, there is almost always a second round.  Rare is the company that is able to develop a strong, sustainable cash flow positive business with a single round of financing.  When that bridge is crossed, the age-old debate begins within the boardroom:  do we do an inside round and save everyone (especially management) time and hassle or do we go outside and get someone else to price and lead the round?

Frankly, this “inside-out outside-in” dance was always a mystery to me as an entrepreneur.  And now that I’ve been a VC for nearly 3 years, I find myself still confused by it all.

If the VCs around the table love the company, why would they want anyone else to invest in it?  Why not keep investing and continue to (one of my favorite phrases) “put more money to work” (whenever I hear this oft-spoken phrase, I imagine a bunch of George Washington dollar bills slaving away in the salt mines and a VC foreman barking:  “Get me more dollar bills!  I need to put more money to work!”)?

So VCs only push entrepreneurs to go raise money from outsiders because they don’t love the company and don’t want to invest?  But if all VCs do this, then all VCs know this.  Therefore, when a VC receives “the call” from a VC buddy (sotto voice:  “I’m only exposing this to a few folks, it’s moving fast, but I wanted to get you exposed to it because you have such unique value-add and we have such a unique relationship”), the savvy VC buddy gets very suspicious.   A VC friend of mine refers to this as the “VC buddy pass”, and warned me when I got into the business to run for the hills when it comes your way.

And then there’s the famous bait and switch technique – the VC board member loves the company, but their partners are more skeptical and insist on outside validation.  So, the VC pushes management to spend an inordinate amount of time trying to attract interest from new investors, and then once the outside term sheet is put on the table, the insiders decide that they actually do want to invest and keep the round to themselves and shut out (and annoy) the outsider, particularly now that the price has been set.  This is known as the “rock fetch” (VC to entrepreneur:  “go find me a rock.”  Entrepreneur comes back panting hard with a rock in hand.  VC responds:  “No…I don’t like that rock, go fetch me another one.”)

As I said, I find it all pretty confusing.  That said, I have learned that there are mitigating circumstances.  Specifically:

  • Capacity.  There are times when the company’s capital needs are beyond the capacity of the existing syndicate.  Raising $10-15 million of fresh capital can be hard for the two original VCs, particularly if their fund sizes and average capital per firm constrain their ability to split the check while reserving adequate dry powder for another round.
  • True Value-Add.  All cynicism aside (or most of it, at least), there are times when a new, outside investor adds unique value.  This so-called strategic money can come in the form of an institutional VC, a corporate VC or a business partner with an interest in putting a few George Washingtons to work.
  • Market Validation.  As I mentioned in my VC accountability blog, an individual VC partner is accountable to their LPs and fellow partners.  If they continue to support a company on the inside without seeking outside market validation, there is a risk of eroding the natural checks and balances behind cutting off bad businesses and not allowing good money to be poured in after bad.  In my experience, this can lead to a very frustrating outcome for entrepreneurs.

My suggestion:  entrepreneurs should be proactive and have a frank discussion about the next round right after closing the first round.  Something like: “If I hit these milestones, will you continue to support the company?  If so, what is the stepped up price that we will deserve?  20%?  30%?  What if we exceed the milestones?”

Ultimately, the inside-outside dance can be an area of great and unnecessary tension and time-wasting between the VC and the entrepreneur.  As with most things, direct, open communication can mitigate the potential negativity that can result in the dance ending poorly when the music stops.