The Business of Venture Capital. Mahendra Ramsinghani

       Build on first principles, not blind imitations. Elon Musk, when forced to rethink the cost of building a $65 million rocket, observed that the materials required to build the rocket were only 2 percent of the overall costs. That was the trigger for starting SpaceX. Scientists are often trained to think along such lines, but the vast majority rarely develop this skill. Indeed, thinking is the hardest part of our jobs, and very few people do it well. Most of us imitate others, often without realizing it. Aristotle's view said, “In every systematic inquiry (methodos) where there are first principles, or causes, or elements, knowledge and science result from acquiring knowledge of these; for we think we know something just in case we acquire knowledge of the primary causes, the primary first principles, all the way to the elements.” The Socratic method of questioning (discussed in due diligence section) can be applied here, where we ask ourselves, “What data and evidence do I have — why do I think this way?”

       Hang your observations together in simple mental models. Charlie Munger, investment partner at Berkshire Hathaway, described mental models and frameworks as follows: “The first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. You've got to hang experience on a latticework of models in your head.” Mike Maples, Floodgate Fund, encourages investors to “Build your insight hypothesis on selections you make — founders or companies.” For example, an observation can include a hypothesis like immigrant founders are hungrier as they have burnt all bridges, hence they have a higher chance of success. Or you could develop a hypothesis around certain market segments, adoption patterns, buyer behavior, and so on.

       Build your circle of competence using probabilistic thinking. As investors, we can operate in some areas really well. And we can do poorly if we try to get into every corner of the marketplace. Because our entire business is based on outcomes, we need to make quality decisions that separate skill from luck. In her book Thinking in Bets, author Annie Duke writes, “We are betting against future versions we are not choosing.” We suffer from hindsight bias (after the outcome is known, we of course knew it to be inevitable) blind-spot bias (where we cannot see our own bias and shortcomings), and self-serving bias (attributing wins to skill and failures to luck). We need to build a good process for decision-making. We gather details, build our knowledge, but also are aware of what we do not know. We apply uniform standards to data and watch for conflicts and self-interest. In making venture investments, “we should understand the power law,” Mike Maples reminds us. The power law states that outsized returns come from a handful of companies while the vast majority of investments yield an average outcome. “How can we know which risks are worth taking? I passed on Airbnb — what questions should I have asked instead?” he says.What Makes a Good Investor?Personality, Brains, EnergyFor a venture capitalist, I think you want brain power and you want energy and you want personality. Want somebody who is going to attract people … It goes without saying you want somebody dead honest, and you want somebody that's got really good ethics, and you want somebody who's got a strong sense of pride in getting the job done. And then I didn't mention the analytical side… .¹—William Draper III, founder, Sutter Hill Ventures

       Study game theory. In the game of VC, you have competing investors, follow-on and strategic investors, founders, competition, partners … the whole gaggle where interests can diverge. As the simplistic definition of game theory goes, you are trying to predict the next move in any strategic interaction between multiple players where everyone knows the rules and outcomes. Game theory can be a powerful tool to understand possible outcomes where you sort out messy situations. You often have the following dynamics at work:Game: Any set of circumstances that has a result dependent on the actions of two of more decision makers (players). Assume the CEO and the board/investors are players, aiming for a certain outcome.Players: A strategic decision maker within the context of the game. In VC, the primary players (CEO, board) as well as secondary players (competition, regulatory forces) can impact the outcomes.Information: All sides have varying, and partial, information of the state of the business, market, competitive dynamics and moves being plotted.Strategy: Actions and circumstances that might arise along the way.Outcomes: Win, lose, or continue to build — these dynamics can vary with any number of moves made by the players.Though performance matters, politics and power dynamics can kill you. Many VC careers have died a premature death, thanks to ego, greed, and politics. While you may be innocent, know that this is a high-stakes game. Self-preservation and “jumping in front of the right deal/parade” occurs all the time. One investor reminds us that you have to earn your political capital in any firm — know who is in charge and understand the power dynamics. You could be the smartest person with top-decile returns, but if they don't like you, they will find a way to kick you out. In another firm, a young but insecure power-hungry partner played diabolical moves and eliminated a senior partner because he felt threatened. The senior partner had a proven track record, strong network of relationships, and could source better opportunities. But he was eliminated because, according to the party line, he was not a “team player” and did not follow the firm's “culture and processes.” “I had to make a decision — should I keep my $500,000 a year position to become a lap dog? I chose self-respect and peace-of-mind instead… .” this GP bemoaned.