Bad Pattern Recognition Gone Wild

Seven years ago when I first started in the world of Venture Capital, I tried to spend as much time as I could with seasoned Investors to learn what I could through their experiences.  I figured that borrowing a degree from someone else would be easier than earning it from scratch.

It shouldn’t come as a surprise that much of the advice was generic and of the “no duh” variety.   After a handful of conversations the wisdom being shared with me about how to spot a great business started to sound alike.  Only back great teams.  Serial Entrepreneurs succeed more than first time Founders.  Back businesses with low burn rates.  Make sure that the business is serving a large addressable market and solving a real problem.  Answer the question “is the market ready now”?  And on and on and on the genericized list went.  My conclusion at the time was that making good investment decisions collapsed to an exercise in Pattern Recognition and was even told such by many very successful investors who prided themselves on their skills in the space.  Invest, analyze, learn, repeat.

Fast forward seven years and 50+ funded companies later and I have a very different perspective about what it takes to be a great investor.  And one of the pieces of advice I would give about investing is to make sure that you don’t fall prey to bad pattern recognition.

While this sounds as obvious as a lot of the other genericized advice given to me many years back, I think it’s a concept that’s worth talking about, especially given the immense amount of bad pattern recognition I’m seeing in today’s market.  The key is to know when to trust previous patterns and when to ignore them — not a simple task.  Sometimes art needs to override science and intuition needs to override history.  This is one the keys to being a great investor.

For instance, one of our very young companies was looking to raise its Series A recently and the amount of bad pattern recognition I experienced in discussions with potential investors was astounding.  The company was growing at a 20% month-over-month rate for the previous 9 months and there was no reason to believe the trend was going to stop anytime soon.  The business had a very solid business model and was addressing a large and obvious problem for a sizable market.  The burn rate was very reasonable and there weren’t too many leaps of faith necessary for the company to build a very impressive business.

But here’s just a few examples of the unbelievably bad pattern recognition I heard from potential Investors….hang on to your hats….some of them are doozies:

Incredible Investor #1

“We don’t like the business because nobody can make money selling into businesses with under $2MM revenue a year.  We’re investors in (very prominent business) and (very prominent business) can’t make money in this segment.”

Hmmm….our business is generating around $6,000 of revenue annually per customer from this part of the market and even when faced with facts and the backup rationale for “why” they wouldn’t believe the company.

Incredible Investor #2

“We don’t like the business because there’s a well-funded (notable accelerator) company in the space and we don’t think going head-to head with them is a prudent idea.”

Hmmm….I’ll never say a bad word about this notable accelerator because I like what they’re doing quite a bit and believe they’ve helped some incredible businesses.  But to think that the mere presence of a competitor that came from this accelerator is a signal that another company is doomed is silly.  Investing isn’t like the Highlander movies….there can be more than one good company to back, especially when a market leader has yet to emerge.

I’ve also seen really bad pattern recognition recently when talking to Seed Investors about a company that’s Angel funded by yours truly (Nestiny).  The company is located in Richmond Virginia with a female first-time Entrepreneur so you can imagine the pattern recognition that we’re fighting against.  Why not hear out the idea instead of “triaging it away” based on very rigid investment criteria?  Is it inconceivable that a great business could emerge from a smaller city?  Is it crazy to think that good ideas can come from a non-20 something out of the Valley?  The Founder has significant domain expertise and a very solid business model — all it takes is a single conversation with her to catch the fever.  Nestiny is doing just fine and is being watched closely by some very talented investors, but it was surprising to me how many doors were shut before learning a single thing about the company.

And for what it’s worth, one of the best companies we ever funded was a result of the QED Partnership seeing something that others didn’t.  We’re extremely happy to have led the Series A for Credit Karma and it wouldn’t be in our portfolio if we didn’t use our own judgment and ignore the patterns that everyone else thought they saw.  Use your brains people….they’re there for a reason!

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3 thoughts on “Bad Pattern Recognition Gone Wild

  1. Frank, another great post by you. I especially liked your comment, “one of the best companies we ever funded was a result of the QED Partnership seeing something that others didn’t.” It underscores the idea that investing in early stage companies can’t be boiled down to a standard formula.

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  2. Hi Frank, I know many investors believe they have the winning formula to identify successful business. I would argue that it is more of an art than science (i.e. judgmental decision would perform better than using some model for evaluating start-ups) . It’s more than just having the right ingredients. Sure you will increase your chance of success by following some of the more obvious patterns, or like your prior post on reducing risk with the 0.8 to the 5th philosophy. Also I believe that value is in the eye of the beholder. Some people would be excited to invest $100 with a guaranteed 100% return in a year, while some other will think why bother with just $100 (e.g. Berkshire Hathaway won’t acquire business with less than $50MM pre-tax earning). Some people won’t invest in tobacco or airlines industry no matter how attractive the valuation is. Some people won’t invest unless the company own the patent to the technology. So on so forth. With many different opinions out there, it creates opportunities for those who are able to identify them. Hmm.. I think I am just agreeing with your post.

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