Diversification – The Alternative to Market Timing

My friend Jordan Cooper wrote an interesting post a few days ago about some of his predictions of the venture market in 2012. Really smart people end up writing thoughtful posts on the future of the venture market pretty much every year – and I often agree with many of them like I do Jordan’s.

But I’m not a believer in my ability to really effectively time markets. Fred Wilson wrote a post making this point as well last year. I might have a point of view on where things are going, but for the most part, we don’t change our strategy very much. Our core strategy for dealing with the ebbs and flows of markets is diversification and consistency of strategy. I think that over time, this is the best way to handle market swings as a seed stage investor who is a) playing in a highly unpredictable part of the market and b) has a very long time horizon.

Here are a few ways that we think about diversification and consistency of strategy:

1. Valuation Discipline. We have a pretty strong sense of what realistic valuation ranges are and aren’t for seed stage companies. Our model works when our seed dollars go it at a price that allows us to be well compensated for the risk we took if things go reasonably well. There may be little swings one way or another when markets are stronger or weaker, but for the most part, our valuation band is pretty tight (controlling for company characteristics like product maturity, quality of team, etc).

2. Investment Pace and Time Diversification. Our goal is to invest in 9-12 new companies a year. This equates to 3-4 new investments per year per partner, which is the pace at which we think we can be very active with companies during their first few years of life. We try to maintain a pretty steady investment pace each year, although it tends to ebb and flow a little bit based on our deal flow and valuations in the market. But our intention is not to let things swing too much. One of the most overlooked kinds of diversification is diversification of time. By spreading out our investment period over several years, we minimize the amount of exposure that the entire portfolio might have to sudden shocks in the market.

3. Business Profile Diversification. We try to build out a portfolio with some level of diversification on the profiles of the businesses we invest in. At a simple level, this might just seem like sector diversification (eg: not too much ecommerce, not too much ad tech, etc). But I tend to think about it a little differently. We try to invest in companies with different “paths to victory.” We’d like to see some companies that rely on viral consumer adoption. We’ve invested in some that require building a 2-sided market with local businesses and consumers. We’ve invested in some SaaS companies that acquire early customers through a combination of inbound marketing, inside sales, and partners, etc.

4. Syndicate diversification. We discovered the benefits of this through experience. In some seed rounds, we invest mainly with seed investors and angels. But in others, we are investing with large VC’s (although most of the time, it’s situations where the large VC is pretty fully committed to the company and not just viewing the investment as an option). Although I appreciate and agree that there are major signaling risks of taking seed money from a large firm, there are also benefits. One of which is that large firms that have conviction about a company have the capacity to support a seed stage company when times are tough. The last 6 months or so was the period that many VC’s predicted that we would see a “series A crunch”, and indeed, I think this has been the case in the market. But what we’ve seen is that our portfolio companies that had a relatively easy time raising their next round all had large VC funds as committed investors already, and stepped up to lead the series A (and in all cases, fought off outside interest to do so). So for the most part, we try not to be too dogmatic about syndicate partners. We just look for syndicate partners that are very committed to the companies they are investing in, and we’ve naturally seen a pretty even split between rounds with large VCs and only seed and angel investors.

The takeaway for entrepreneurs isn’t very straightforward. As an investor, I’m building a portfolio, but a founder has a portfolio of one. My advice then is essentially to gravitate towards investors that a) have a disciplined strategy and b) see you as falling into their core strategy. It’s dangerous, IMHO to be a non-standard investment for any fund. If a VC has a secondary “program” for your kind of company, or if they are “bending their rules” to invest, I think that’s a signal for some additional risks. In some cases, it works out fine. But what you really want is a VC that digs their heels in when times are tough. And that’s way more likely when their investment in your company fits into their core strategy vs. some other “non-standard” bucket.

Rob Go is a partner with seed fund NextView Ventures. Opinions here are entirely his own. Rob blogs here and tweets here.