Wednesday, April 8, 2015

Venture Capital After the Pao Lawsuit

Ellen Pao lost the lawsuit, but started a national conversation about the scarcity of women in venture capital
Something seems to have been overlooked in the wake of Ellen Pao's failed lawsuit against Kleiner Perkins, the powerful Silicon Valley venture-capital firm.

The discrimination court case received volumes of attention in the media, which not only reported the case and its verdict, but disseminated streams of statistics, stories and insider tales from witnesses. Those on the stand chronicled Pao's time at the firm and described the environment of working in the industry, making investments, supporting new ventures, and reaping millions.

A jury ruled in favor of Kleiner Perkins, but close observers of the case concluded it was a victory in some ways because the case was, in turn, a full-blown forum to determine who's to blame for the scarcity of women in senior venture-capital roles, while the industry enjoys one of its most blooming times.

Amid the discussion and debate, something was missing.  Women, reporters of the case pointed out often during the trial, often have less-significant roles in venture capital and private equity. Statistics show women comprise less than 10% (6% in recent surveys), of the principals, partners and directors at the major firms. However,  the recent discussion about the court case seldom got around to analyzing another truism in the industry--that there is also a blatant scarcity of other under-represented minorities who work at these same firms (namely, African-Americans and Latinos).

Or perhaps that fact goes without having to be stated prominently. A scarcity of women in this arena usually and automatically implies (like a corollary) there will be few Latinos and blacks sitting in the partners' rooms, making investments, leading deals, supporting entrepreneurs, and selecting the ideas that which will be afforded venture funding.

Beyond Pao's allegations of discrimination, the trial's transcript offered several recounts of what goes on inside a venture-capital outfit:  How do principals make decisions? How do they decide investments to fund or entrepreneurs to support? What skills are most important to succeed as a venture capitalist--relationship skills, people skills, technical knowledge, deal experience, negotiation skills or analytical skills? What does it take to become a partner, principal or director? And who decides?

Skills, skills, skills.  In most financial institutions (from global banks to boutiques and private firms), senior managers like to pronounce their organizations as meritocracies and say those with special skills and expertise will be promoted to the highest rungs. In venture capital, what are those special primary skills that help firms reap vast returns on investments, skills senior partners want to see before they promote associates to senior levels? As outsiders have asked often, why are there still so few women, many of whom likely possess or could certainly gain the same skills and expertise to become leaders in venture capital?

The trial, nonetheless, helped confirm what many already knew or what some don't want to always admit. Skills, knowledge and networks count for much.  But "some special magic" to hit venture-capital home runs is necessary. Luck is involved. Where does this "magic" come from, and why does it appear that a small group of men monopolize it?

The Necessary Skills

Successful venture-capital investing or identifying lucrative opportunities requires a combination of skills, external factors and good fortune at any of several stages of venture funding. Seed investing, incubator support, angel investing, early-round investing, mezzanine and debt funding, and private placements comprise the several rounds of funding activity before the new enterprise decides to issues equity shares to the public (or sell out to another company).  A venture-capital firm may step up to provide funding (and guidance, direction and management) at one or more of these stages.

Those who have outstanding track records (the big names in the industry, usually the names on the front door) will possess many skills and know how to capitalize quickly on opportunities and bonafide good ideas. Those who rise within the ranks of a firm will have proven to senior partners in some way they have the skills, capitalized on opportunities and deserve promotion. Or they were successful in conveying the importance of their contributions.

Some of the skills and factors can be assessed from quantitative measurements. At other times, it's what it is--a sometimes rash, subjective effort.

 a) Knowledge of the industry.

Shrewd venture investors must understand the industry, products, technology, and the requirements to start businesses in that industry and shape them into highly valued, stable, profitable organizations.

b) An understanding of risk tolerance.

Good investors understand risks in business and in investing and understand risks-vs.-rewards metrics (seeking ample rewards and being patient about reaping them for the risks they will absorb over the long term).

They understand their tolerance for degrees of risk and understand how to hedge, reduce or avoid certain risks.  Venture firms, by definition, take risks, but want to be prudent about them. For example, they reduce risks of investments by ensuring the companies they oversee are run by experienced operational managers, by managing costs efficiently, and by unveiling new services or products at the right time.

c)  A long-term vision.

Along with the entrepreneurs they finance, they, too, have a vision for where they see the product, company, and its markets in 2-5 years. If they don't have the vision yet, they devote time trying to develop or craft one, at least one that will eventually result in growing revenue streams.

d) Contacts and networks within the industry.

The best investors know who's who, what's what, and where's where. They cultivate relationships with successful entrepreneurs, other investors and institutions, experienced engineers and computer scientists, and big banks.  They know details of start-ups, technical planning, and product ideas. The conversations of what's next, what others are dreaming of, and what experts are thinking about flows through them. Or they ignite the conversations.

d) Financial analysis.

Financial analysis is often taken for granted.  But venture investors, like others who do well in investment management, have targets for how much they are willing to invest (over a set time period), what amount of return they expect and when they want it (a short- and long-term ROE), and what is a potential public-market value of the stake they hold. They can compute and rationalize the long-term value of an investment in public markets or in the eyes of a potential acquirer.

They are experts in the quantitative analysis of valuing companies, especially companies that have no profits, no track records, and often not yet a marketplace.

e) Experience and expertise in deals.

Doing deals involves structuring, innovation, pricing, negotiation, and execution.  Expertise in decision-making and deal structures usually follows from experience.  Expertise also implies apt timing--determining when to invest in early stages, when to do follow-up rounds of funding, when to take on other investors (both debt and equity), when to go public, and even when to sell out, if that is the right step.

f) Intuition and insight.

Venture capitalists do well, in part because they have intuition, special insight regarding the demand for a new product or service or an understanding of the customer base. They use insight to formulate a vision for what a company will be 5-10 years hence. They and the company founders will often have shared, common visions.  There is no unique way to call up or exploit insight, but insight exists because someone has competence in other areas (technical and product knowledge, broad networks, financial analysis, deal expertise, etc.).

Some say this is the "magic" or the "it" factor that some senior partners have and others don't, the knack for knowing what's right, what's next, or what will work.

Unfortunately, at least in the case of Pao and for others like her, evaluating an ability to have uncanny insight often requires subjective judgment.  It can be based on a past track record or it is inferred from experience. Most in the industry prefer not to call it for what it frequently entails:  good fortune, good luck, perfect timing.

g) Economic factors

Understanding the economic factors that affect a new company are critical.  The value of investments or the prospects for surging growth for a start-up can depend on pure economics: business cycles, product stages, interest rates, capital markets, consumer demand, and investors' behavior or liquidity.

Next Steps for the Industry?

The investment competencies above can be learned, experienced, shared, or attained (from advisers or mentors). So why should they be monopolized by small clubs of men in the Bay Area. Why aren't there more women, Latinos and blacks working at and rising to the top of Kleiner Perkins, Andreessen Horowitz, and Sequoia?

Do venture firms claim they can't find eager, well-prepared participants from under-represented groups who have most of the skills described above and a knack for taking advantage of opportunities?  Do they prefer not to be the first to bring them into these closed, private circles?  Are they unwilling to develop or nurture under-represented talent in the way they do for sons and daughters of classmates and fellow board members?

Or is this more an unconscious unwillingness to share the rewards from a booming, lucrative pie with groups other themselves? (High stakes imply closed circles?)

Some of the recent top firms are old-boy circles, circa 1998, circa 2005. Some (e.g., PayPal, Linkedin, and Netscape) are start-up entrepreneurs who reaped millions (billions?) in an early ventures, explored other side ventures, and eventually decided to establish themselves as managers of new venture-capital funds.  After stints managing new companies and sweating out an operation from dorm-room idea to billion-dollar IPO offering, they formed new firms to manage new wealth and to focus on selecting the newest new thing.

The circles of familiar faces invest in and support ideas and companies within tight spheres, share insights with each other and anoint the next generation of the best entrepreneurs to appear on the scene since Zuckerberg (Facebook) or Spiegel (Snapchat).

Most, including Ben Horowitz or many from Kleiner Perkins who were escorted to the witness stand, say the want to do their part. Some have tried, but are flummoxed by how to do it or distracted by typical business concerns.

The trial is over. The editorials and commentary have been written. The commitment to change (or at least do better) has been voiced. The discussion about what needs to be done has peaked.  Where do we go from here?

Will the industry take bold, sometimes brazen measures to ensure they open their doors and create more inviting environments for women, blacks and Latinos?  Or will it retreat back to the status quo after the publicity swooning around Pao wanes?

Tracy Williams

See also:

CFN:  Venture Capital Diversity Update, 2011
CFN:  Knocking Down Doors in Venture Capital, 2012
CFN:  Horowitz and His Latest Venture, 2014
CFN:  MBA's in Finance, 2015 Opportunities

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