Alan Patricof, founder and managing director of Greycroft, LLC and a pioneer in the venture capital field, shares his insights on how to become a venture capitalist. Mr. Patricof’s many achievements include establishing the Apax GLOBIS Japan Fund (JPY 20 billion)—which included the highly successful portfolio company GREE—with Yoshito Hori in 1999.
Alan Patricof: I was asked to give this talk today about the venture capital industry and how to be a great VC. I feel like Jim Collins, who wrote that book Good to Great, and who’s got another book that just came out on why companies are great companies.
I’m not necessarily certain how you can be a great venture capitalist, but I can tell you some few thoughts I have about being in the venture capital business and some of the things you might think about.
Patricof: So the first slide says, “Be curious.” And you might wonder what that is, but that’s a picture of a plate. I, for many years have been asked, “What’s the characteristics of a venture capitalist? How do I know if I, you know, am a good venture capitalist?” And I came up with this concept many, many years ago. And I said, “If you went to a dinner party and you saw an unusual plate in front of you. If you took the plate and you turned it over, and you looked at it and said, ‘Who made it?’”
That was an interesting test of the fact of you were a curious person. I won’t even ask for hands how many of you’ve ever done that. Probably none of you. But I think it’s suggestive of being curious enough to find out something.
And I think if you extend that concept, not just to plates, but to products or services or articles that you read or papers that you read or attending conferences… I think if you’re the kind of person who is curious about what’s going on around you and asks questions and doesn’t take things for granted. I think that’s the characteristic of someone who probably, as an early precursor, would probably make a good venture capitalist.
Now you may say it’s very simple. But the truth is that most people in life don’t go around and aren’t curious about what’s going on. They don’t read something in the paper and then go and check it out—check out website, check out an article, check out a person. Because if you really want to be good in this business, I think you have to be the kind of person who has that curiosity factor and looks a little further than just the obvious.
Patricof: Now, the next picture, I hope you can determine, is a target. “Be focused.”
When I started out in this business, it was a very diversified business. My first investment was in the secondary metals business. The second was when the animal feed business. The third one was actually the first internet startup—in those days it was called “packet switching.”
It was such a new industry, it wasn’t even an industry. It wasn’t called venture capital. You really were looking for any opportunities you could find where someone was looking for capital. The concept of sharing and giving a piece of your ownership of your business away was a very unusual concept. It was then, frankly, when I met Yoshito Hori and his team. When I first met them in 1998, the concept of sharing ownership was a new idea.
I started in Europe in 1977, 1978. It was a totally new concept. People couldn’t get the idea. They were used to borrowing money, but they weren’t used to taking on equity partners. And that problem still exists in parts of the world today. In Africa, it’s a very big problem. People need money desperately, but they are not used to the idea of sharing and partnership.
The point is that business has evolved in the more developed areas today. Certainly in the United States, we’re developing expertise in a particular area. I think it makes a lot of sense for someone who wants to really build up their skills in this business. I think developing deep relationships with people who are operating in the area so that you get to know who the people are, who are in the leading edge in technology so that you can have an exponential growth in terms of your contact level.
We are very, very focused in the digital media area. And one of the biggest strengths of our firm today, Graycroft, is the fact that companies want us as an investor because of our significant network in the digital media and mobile area.
So I’d say, if you wanna be great in this business today, you have to develop a particular expertise and you have to learn how to focus your efforts. Because if you get too diversified, you’ll build no reputation for expertise. It’s a competitive business today. Entrepreneurs want investment from people who understand their businesses. They don’t want to educate them from the first day as to what they’re doing.
Patricof: “Be disciplined.” This is a chart which shows you the investments that were made in the venture capital industry year by year from 1990 to 2010. It skips two years at a time.
You can see for yourself the famous bubble of 1999, 2000. It’s very clear. That’s when discipline went totally awry. People just put money in indiscriminately. They backed people who had no experience running businesses. Most of the people who were starting businesses were too young. They should have been, you know, working in companies as opposed to starting businesses. And the venture capital business was over-financed by institutions. And as a result, that’s what happened. The investments went from $100 billion down to a low of $14 billion in 2010.
You wanna be an investor when the drums are rolling, not when the trumpets are blaring. When everybody’s excited, when everybody can’t wait to get into the next deal, that’s the time probably to slow down. Be careful. As opposed to when everyone’s discouraged.
I would say that probably, particularly from a Japan standpoint, I would think this is probably gonna turn out to be a great time to be an investor in Japan. As long as you use appropriate discipline about the companies you go into, I would guess that valuations in hindsight are gonna turn out to be very good. And I think it’s probably a very good time.
At the same time, we’re going through a period where, because of—in my area, in particular—broadband communications and the spectrum that’s available, because of outsourcing, because of cloud computing, because of the mobile networks, the capital efficiencies of businesses that are starting out has never been greater. So you can start businesses with a small amount of money. I think that if you’re disciplined, and you invest in companies that know how to take advantage of capital efficiency and know how to structure their business appropriately, and you invest your own money on a stage-basis where you don’t just pour lots of money, I think you can do very well.
I happen to believe very strongly in the moment, which is why I started up again from the beginning in 2006. I started a fund that was by design a small-size fund investing in capital-efficient businesses. I had had many years of experience in building a very big firm. Apax, certainly, has gone from being a venture capital firm to being a mega buyout firm. Their minimum size investment today is probably $500 million—five times bigger than my whole fund.
But they’re not venture capital. If you’re gonna be in venture capital, I think you have to learn how to be disciplined about the money you raise, how you invest that, and how you stage the investments.
I am not a big believer in big venture capital funds. I think there’s an inconsistency because you end up investing too much at too high a valuation. And the exit opportunities are not commensurate with the capital that you may be employing because the world has changed dramatically.
Not so much for Japan, frankly. Based on my superficial observations, Japan is a better place to invest with an IPO expectancy than the States today. Ten years ago, every company I looked at, at the end of the presentation would have “exit in 2015 through an IPO.”
Today, nobody expects to exit in an IPO. The IPO market is very, very limited in the United States. You have to have a company of at least a market cap of $300 -400 million. You have to raise $50 million. And then you have to worry about whether there’s research coverage afterwards and marketability.
My sense of Japan, based on my experience from coming here every couple of years, is that you can virtually make an appointment to take a company public. You can do small cap IPOs. There’s reasonably good markets afterwards. And certainly, Apax GLOBIS and then GLOBIS has taken advantage of that.
In the States, don’t be carried away. I’m sure you all are reading in the American papers and the Japanese papers about Groupon and Zynga and Twitter and Facebook—they’re a very unique subset of the business. And anyone who gets carried away by that is making a very big mistake.
The opportunities . . . You know, there are probably at least 2,000 venture startups last year, and maybe five or ten will go public. The rest of them will get sold in some kind of trade sale. In our experience, the average trade sale is taking place at $70 million. In terms of numbers, most of them are below $50 million.
So learn how to discipline your investment. Size your investment in relation to the realistic opportunity for exit. And don’t lose sight of that when you hear all these fancy stories.
Cultivate Your Network
Patricof: Cultivate your network. I mean networking. That’s what you’re doing today.
Meet the people who come to the same events you do. If you go to the event and you leave, or you sit next to the same person you came with, that’s not developing your network. Developing a network gives you this ability to be able to focus in an area and be able to call on other resources. The best deal flow comes from your existing network, not from strangers. The amount of deals that are done in the venture industry from unsolicited proposals is so small that, the temptation is always for everyone just to turn them down automatically. It’s so unlikely that something comes of it. All of us are creatures of habit.
We still open up those emails and meet with them once in a while. But the best deals come from people that you know, who you’ve developed through your network, who you can calibrate their experience.
I would say along the same lines that we have learned one really major lesson in this business. The best investments we have made have been with entrepreneurs who start new businesses in areas that are somewhat closely related to what they did before, and where they attract people they worked with before to a team. The highest probability of success.
We have a company that’s called Extreme Reach. It’s not important what it does, but it happens to distribute for advertisers, for brands. It distributes ads across the TV, radio, and now digital networks. And they all work for a company called DG Fast Channel, or something on that line. The CEO left. He had a two year non-compete, and then he decided to go back in the business.
Before that, they had been distributing these advertisements through what I call the “bicycle network.” They would put them in a FedEx box and send them around or messenger them around to the stations around the country. And then it gradually moved to satellite distribution. And with the advent of the internet, the opportunity came to create a capital-efficient business that would distribute the exact same ads on a HD basis, high-definition basis, through the internet.
So he created a company about two and a half years ago. And he came with a team of about five people, all of whom worked for DG Fast Channel before. They were taking a new technology, capital efficient, and with the same group of people who’d worked before, who had experience in the area. Today, he has about ninety people, and seventy of them came from DG Fast Channel. All very legitimate, all left with the right, appropriate non-compete restrictions.
This is probably the fourth or fifth company we’ve backed where it has that kind of consistent group of people who worked before. So it’s helpful to network to recruit for your companies. It’s also helpful co-investing with the people who go to these meetings with other venture capitalists.
We believe very strongly in co-investment.
Probably most important is… The biggest strength our firm has is that we promote the investments. We talk to the entrepreneurs. We will help you building your business because of our network. Because of the cultivation of our network, if you need to meet an advertiser or someone in the entertainment business, or in the media business, one of the TV or radio networks, we have built up this extensive network of contacts, particularly in the advertising world.
And most companies on the internet in our digital world today need to have advertising. That’s the reality. And so we have become a very popular firm for entrepreneurs because we deliver the introductions through our network.
We run Digital Media Day where we have an ad agency in, and we let them pick from our portfolio, and we give a show and tell. We do it for the brands. We do it for the networks. We did one last week for Citibank. We did one for Bank of America. We did one for American Express. And it’s an amazing opportunity for our portfolio companies, who are all young companies and desperate to get to the right person. They can have a meeting where they can meet ten, fifteen people in one place and sell their merchandise or their services.
So cultivating your network is extremely important.
Identify talent. I assume all of you know who this is better than I do. Clearly, the people at GLOBIS were smart enough to identify talent and surround yourself by good people.
Use the concept of “venture partner.” A venture partner is not a full-time person, but someone who you add to your network, which you probably couldn’t afford to hire.
Develop an advisory team where you also can access other sources besides your firm itself. We have used that extensively to get better leverage. At our firm, we have on our full-time staff five full-time people. But we have three venture partners, and we have an advisory group of five CEOs from outside companies. And that provides our network to be, again, helpful to our companies.
Remember, you’ve gotta help your entrepreneurs in recruiting talent, not just identifying the initial talent. You’ve gotta also help them—recruiting is part of the job.We invest in people first. The product is secondary. I would rather have a great person and a great team than have the most terrific product.
After Russia had its change in government and structure, we must have seen—honestly, I’m not exaggerating—at least ten, maybe twenty people come to us and say, “I have access to all the technology out of the Institute of Aeronautics! I have all the technology out of the Institute of Physics!”
There was always someone coming in with all, a hundred people, hundred software engineers. “We have access to all their talent!” But I used to say to every one of them, “Where’s entrepreneur who knows how to capitalize on that talent and make something happen?”
Talent is the thing that’s in short supply, not necessarily the technology or the product itself.
So you really want to ask the next question: “What makes a great entrepreneur?”
- The ability to inspire other people is very important.
- The ability to attract talent. As I said, particularly people that they’ve worked with before.
- An enormous persistence that, in spite of adversity, they don’t give up, but they have belief—an informed belief, I would say. Not an uninformed belief. Because there are people who are entrepreneurs who just don’t give up, who aren’t willing to read the signs and accept the fact that something’s not working. So there’s gotta be a balance there.
I think also, as part of that, understanding the economics of the business, they’re going into. A lot of people go into business and they say, “We’re going to business, and it has a $10 billion market.” That is really, probably not the case because the address market is the segment of the market of that big market they’re really going after. And that may be much smaller. And the economics of reaching that market are very important.
The one failing we find in a lot of entrepreneurs is not understanding what the marketing costs are and what the distribution costs are and how to get to that market that they think they’ve identified.
So identifying talent and being helpful yourself in recruiting talent.
Understand Venture Capital Is an Apprentice Business
Patricof: Venture capitalist is an apprentice business. If you can’t tell with this picture, it’s a shoemaker. There aren’t many of them around the United States anymore. We used to have one on every block. I don’t know about you, but it’s very hard to get your shoes fixed. You throw them away now, I think.
[Venture capital] is an apprenticeship business, which is what shoemaking was at one time. Venture capitalists, I don’t think, are just made. I think having instincts, having curiosity, having all these characteristics that I’ve talked about are important.
But you really have to learn on the job, which means starting out in a junior capacity and, and learning. Don’t think you know it all from the beginning. It takes time to develop this ability to identify talent and to judge what makes a good deal and what doesn’t. And I think you can learn from others. Watching what doesn’t work is probably the best thing you can learn.
The question always comes up. I get asked this, and I’m sure you’re asking yourself if you’re not a venture capitalist: “Should I go into the venture business? Or should I, should I go into the investment banking business first? Should I go into a startup?” I think that all depends on you. But coming into the business with some skill level is very helpful.
I frankly believe that having been in a consulting firm or having worked for a startup or an entrepreneurial venture gives you a better ability to get into the venture business. Although some people come straight into it out of business school or out of another industry. But even if you come from another industry, you have the expertise from that industry.
An apprenticeship business means that you’re not gonna be an overnight success.
Patricof: Empower your entrepreneurs. I like to always say, you’re not the entrepreneur, you have financed an entrepreneur. Unfortunately many venture capitalists get confused about what their role is, and they become overpowering, and they try literally to run the business.
If you get too aggressive and too overpowering to your entrepreneur, he may turn to you and say, “Here’s the key to the front door. It’s your business.”
I actually have seen that happen because of venture capitalists becoming too actively involved. I tell the story of someone who worked for me many years ago. He was very, very smart. He was a physicist by training. He taught at Princeton, as a matter of fact, and he had worked at a company before, and I hired him. He was out in my West Coast office. And we weren’t doing that well. We weren’t networking well enough. We weren’t getting involved in enough of the good deals, and I got concerned. So I decided to move out to California for a month to see what was happening.
In the venture business, very often the venture capitalist will be the chairman of the board. The chairman of the board, in the way I interpret the chairman—I’ve been chairman of several companies—is you preside at the board meeting and you say, “I will now turn over the meeting to the CEO.” The CEO then runs the meeting.
That’s the function of a chairman. He convenes the meeting. He provides some stature, some gray hair perhaps, some, overall perspective on the business on grander matters. But he doesn’t try to run the business.
So I had this fellow, he was very smart, and I couldn’t find him most of the time. He was chairman of a bunch of companies, and he was always out at a meeting. And I was finding that he’d have these meetings at six o’clock at night. And he interpreted the role of chairman as really running the business. So he was having marketing meetings for this company, and he was having technology meetings for this company.
We had an investment in a company called Johnny Rockets, which was a hamburger chain. And I got called up one day while I was out there by one of the board members. And they said, “We’re removing this particular person from the board.” He was chairman of the board! And I said, “Please don’t do that. It’s embarrassing, but why are you doing it?”
“Well,” they said, “He is now ruling. He has told the business that they can cook the hamburgers at (whatever it was) 99 degrees instead of 97 degrees. Because he’s determined that’s the temperature at which hamburgers should be cooked.”
And I said, “This is really . . . We’ve now gone to an extreme where the venture capitalist in the business has gotten so involved that they determined at what temperature to cook the food.”
Needless to say, he didn’t stay in that company very long. I don’t think more than a day more. And he didn’t stay in the venture capitalist business very long.
But the illustration is to point out that you just can’t get too involved in the businesses. You can give guidance, you can give support, but you must empower your entrepreneurs. They’ve gotta feel it’s their business, not your business.
Develop a Relationship with Your CEOs
Patricof: Along the same line, I think you have to develop a relationship with your CEO. It’s a very lonely job, being a CEO. Particularly when there are problems.
Believe it or not, it’s hard for a CEO to talk to his vice president of marketing, or certainly his lower employees, to tell share with them the problems that he has. The venture capitalist should be, if not his best friend, someone he feels he can talk to and confide in about the problems that he’s going through and to get a sympathetic ear and a constructive ear.
It’s a very important thing to build up relationships with your entrepreneurs. Let them feel comfortable, like they can tell you the things that they’re going through that are their problems.
And these relationships should last for a very long time. I have many, many entrepreneurs that I still keep in contact with that I was on the board or in the early formation of their businesses. And I think that is an important illustration of whether you’re building your relationships.
And from that, I think you build a reputation for yourself.
Prepare for Adversity
Patricof: When people ask me about what I do for a living, and I say, “I’m an, a venture capitalist,” they say, “Well, what’s that?” I say, “Well, I’m a doctor of investments. And every day one of my patients is dying, and it’s never the same patient two days in a row. That’s the venture capital business.”
I’m sure for those who are in the venture capital business, you know what I mean.
Venture capital is not all going up in one direction. It’s not all positive. Frankly, it’s just the opposite. It has lots of problems because businesses have lots of problems. People quit on you. Financing gets tight. The product doesn’t work. The market is delayed for a year. All those things come about.
I talked to you about relationship with your CEO. You have to also be prepared for adversity. And you have to understand that it just goes with the business.
The greatest ball player in the United States that ever lived was a man by the name of Ty Cobb. Did anyone ever hear of him? No. He was very, very famous. And Ty Cobb’s batting average was something like 365. What it means is one out of three times that he came up to bat, he got a hit. The other two thirds, he struck out. Michael Jordan, who’s probably the greatest basketball player in the United States, his shots in the basket run under 40%.
So the realities are in most businesses, you have a loss ratio. And venture capital is probably one where the loss ratios are higher. People usually say, you know, 20%. There are many funds I’ve seen where the loss ratios are as high as 30%, 40%. You certainly don’t invest with the expectation you’re going to have that kind of loss ratio, but you have to be prepared for losses. And you have to be prepared to deal with adversities.
Patricof: This is very important. It goes with curiosity. If you’re gonna be in the venture business, you have to like multitasking.
If you’re someone who says, “Don’t bother me. I can only focus on one thing at a time,” don’t go into the venture capital business. Because you not only have to focus on many investment opportunities at the same time, but there are all different CEOs. There are different locations. There are different problems.
And not only do you have to look at a lot of different businesses at the same time, but after you’re in the business, you have to be able to be helpful in recruiting. You have to be able to be helpful in financing. You have to be a good board member. You have to be a good investor. You have to be good to help them in business development. So it’s a very diversified field of activity. And unless you like that multifaceted part of the business, I would strongly suggest not coming into the business.
And there’s nothing wrong with that. I mean, Steve Jobs had a focus on building his business, and he would’ve hated the venture capital business, I’m certain. And you could go through many other people. Howard Schultz built Starbucks. He was totally focused on building this coffee chain. He’s been doing it for twenty-five years, and he loves it. I’m sure he happens to have a little venture operation on the side, but that’s not where he spends his time.
I think that there’s a lot of satisfaction that comes from being an entrepreneur. To build it and to say, you know, “I started it. I grew it. These people all work for me. I have something to be very proud of.” The venture capitalists can only say, “I’m proud of having invested in that company.”
I wasn’t the original, but I was the second investor in Apple. I’m proud of having invested, but I could take no credit for the success of Apple. Steve Jobs deserves the credit for Apple.
So if you’re the kind of person that, you know, likes to be involved in a lot of things and thrives on that, then you’ll be a great venture capitalist. If you don’t, I would say, be an entrepreneur. Build a company, and focus on the building that the best you can.
How to Get into Venture Capital
Patricof: So those are my suggestions of things that would be helpful. I think that being also a person who is meticulous about what they do, is focused on detail aspects, of analysis, of fact checking, of reference checking, all the things that are mundane. Those also go with the business. So you have to be really willing to do that intensive analysis besides just using your instinct.
I think you want to be someone who’s willing to put the time and effort to determining the good entrepreneurs, determining the good business models, and then sticking with them afterwards.