THE BLOG
02/16/2011 04:29 pm ET Updated May 25, 2011

Fool's Gold For Venture Capital Investors

Over a career as a financial journalist that spans decades, I've interviewed a hundreds of investors and entrepreneurs in high tech. I frequently ask them what's the most important factor in their investment decisions. The answer is so predictable, I've become skeptical about it, something to the effect, "We bet on people, not ideas. We're looking for an intelligent entrepreneur with a successful track record. The idea is almost secondary."

But can truly great ideas for companies really be separated from the people who generate them? If not, then are VCs and angels today operating on a myth? That myth is fool's gold for investors. It needs to be critically examined and challenged, because it results is a process that maximizes the clutter of the serial entrepreneur and minimizes the chances that the inspired entrepreneur will be recognized and funded.

It's a myth based upon convenience -- the convenience and relative simplicity of evaluating entrepreneurs' track records, in preference to the complexities and challenges of evaluating the potential for greatness in their thinking and ideas. If the VCs are doing their job, both as mentors and funders, then the power inherent in great ideas will attract the talent needed to successfully execute them.

To understand why investors choose the convenience of this myth, let's look at the pressures on investors. First, investors consider their most valuable and scarce resource to be their time. As a result, most, who are in the business professionally, work from a template for investing that enables them to leverage the value of that scarce resource. The question for investors is, "Does that template for investing allow them to recognize and evaluate truly great ideas and entrepreneurs?"

Second, most VCs are answerable to their LPs, who exact high demands in the form of above market returns. To achieve this, VCs look for a minimum 5x return with a viable exit strategy within five to seven years. They play the odds, always looking for the home run that will bail out their losers. Even if four of five investments fail or limp along at break even, the home run will more than make up for it, and make them look good with their LPs.

Now, let's take a look at the history of the tech sector for the last 20-25 years. If the successful startup track record is so important, and investors are really looking for the home run, how does that jive with history? If we try to pick the the 11 biggest home runs during this period, we're looking at the likes of Microsoft, Oracle, Sun, Apple, Yahoo, AOL, eBay, Netscape, Amazon, Google and Facebook. Some might argue for additions or deletions, but for a first cut, it's a pretty safe list.

Let's look at the entrepreneurs behind these home runs and ask if they would meet the criteria that investors are using today to screen their portfolio companies? We're looking at Bill Gates, Steve Jobs, Larry Ellison, Scott McNealy/Bill Joy/Andy Bechtolsheim/Vinod Khosla, Steve Case, Jerry Yang / David Filo, Pierre Omidyar, Marc Andressen, Jeff Bezos, and Sergey Brin / Larry Page and Mark Zuckerberg. Had any any of them started or run a successful company before their home run? Did any of these entrepreneurs have the kind of successful track record that investors use as their benchmark today? One might make the case for one or two in the list, but on balance none would pass the track record criteria that investors place such emphasis on today. Most of these guys were first time entrepreneurs and all did things differently, and that was part of their genius.

Recently Business Week addressed this issue in the context of an article on early Facebook investor Peter Thiel,

One of Thiel's frequent themes is the folly of promoting "extensive" gains over "intensive" breakthroughs. He believes that governments and investors have an "extensive" bias when it comes to science and technology, a desire to replicate or "extend" what has already been shown to work. He perceives a dangerous shortage of the kinds of ambitious, "intensive" innovations he says are ultimately necessary for long-term growth. "My thesis is that the world is too heavily geared in the extensive direction," he says. "It's what everyone would like: a sure thing, something that gets a predictable return. I don't think that model is the right one for our world anymore. But the alternative is necessarily quite risky. And so there's no safe alternative.

Today's investing bias towards serial entrepreneurs who build and flip companies for a living is simply extending the dominant myth in VC and angel investing. It needs to be critically examined if we're going to have investors step up to back the Apples, Amazons, eBays and Googles of tomorrow?