Venture capital investing is a difficult business. An investor must be smart, lucky, and know how to play the game to achieve outsized returns.

We told you earlier that venture capital fund returns have averaged about 12% per year over the long term and 19.7% over the past 20 years according to the Thomson Reuters Venture Capital Research Index. Nevertheless, returns on individual deals, and even on pooled funds holding a number of ventures, can vary considerably from negative to highly positive.

Len's various funds and investment pools over 30+ years have delivered gross annual returns ranging from 14% to 159%. We had to be both good and lucky to never have a losing fund.

Investing in individual deals, though, is difficult, and that's what VC firms do. The venture capital industry norm is that only about 15–20% of all investments will make any money at all, and about half of those money makers will be considered home runs, returning five times the money invested or greater. As we've said more than once in this book (sorry for the repetition, but we're proud of our record), our record is better, with over a third of our investments making some money and almost half of those money makers considered big home runs, with either an IRR of 100%+ or a return multiple on the money invested of greater than 10. Four of our investments and/or companies that we have helped start have reached values of over $1 billion, with America Online at one time having a market capitalization of over $350 billion!

Our average annual gross IRR over 30+ years is 28%, beating Warren Buffett's 20%+ IRR (although he has done this for 50 years). To accomplish such high returns, we had to find the highest quality investments at the right price, and then exit the investments smartly for an excellent gain. Some would say that this is just another form of “buying low and selling high.” However, in venture capital investing, this often‐sage financial advice grossly oversimplifies the challenges and can easily miss the highest quality investment opportunities.

The AOL Story

Earlier in this book, we told you just a bit about the difficulties encountered by the founder of a company in the early 1980s called Control Video Corporation. In discussing the importance of timing, we explained that this unfortunate founder seemed to be a little ahead of his time with his venture. His venture was launched with the idea of downloading video games over regular (i.e., traditional landline) phone lines through a low‐cost modem plugged into an Atari video game console, which would then display the games for play on the consumer's television.

We'd now like to tell you more of this story, as it will illustrate some of the challenges of finding, and in this case also intervening aggressively to enable, the highest quality investments. The initial company, Control Video Corporation (CVC), was funded with about $12 million in venture capital (one of the most aggressively funded VC‐backed startups to that time), supported by a number of the then‐major U.S. venture capital firms, including Kleiner Perkins, Allstate (where Len began his venture capital career), Citibank, Inco, Merrill Piccard, Union Bank, and others.

A major marketing and media blitz was launched, and the product/service was sold at Sears (Sears was America's largest retailer at the time) and other major retail outlets (as there was no functional Internet at the time). The visionary idea was not only to offer the then‐very‐popular video games on demand essentially in real time, but to piggyback on the booming sales of the Atari 3600 Video Game Console and popular games such as Frogger, Space Invaders, and Pitfall.

Unfortunately, the only real pitfall was Control Video itself, which, after burning through all of its investors' capital and owing suppliers another $18 million, essentially crashed and burned, representing a major setback for the venture capital industry itself, which was just beginning to recover from a long dry spell. To the seemingly astute VC investment groups, Control Video initially seemed like a high‐quality investment opportunity at a reasonable entry price, but it went badly wrong and could have stopped the building momentum of the entire VC industry.

When all seemed lost, Allstate, Citibank, and Inco's venture capital groups stepped up and, in support of and along with the company, including its management team, invested even more to buy the company more time, and renamed the company Quantum Computer, which was later renamed again, to America Online (AOL). Prior to AOL's historic 2001 merger with Time Warner, the now‐struggling company (recently acquired by Verizon for $4.4 billion) was valued at a lofty $163 billion, and after the merger was valued at an even loftier $350 billion+, representing the most amazing turnaround in venture capital history and the largest business merger ever. AOL shareholders did very well indeed, with several making billions and about 10,000 making $1 million or better, and this ignited a tech boom in the Washington D. C. area that continues to this day.

You may ask, was Control Video Corporation a high‐quality investment at the right price? It would have been tough to call it a high‐quality investment at the right price after the venture capital leaders initially invested $12 million and saw the venture essentially crash and burn. However, this case study illustrates vividly the value that venture capitalists can bring to the fore, ultimately enabling phenomenal returns even if it looked like a bad bet for a while.

That initial investment brought together a team of dedicated VC investors, who then brought in an experienced turnaround expert, restructured the company, and recruited a new management team that redefined and redirected the business. That redefinition repurposed the modem technology originally intended to bring video games into the home, instead ushering in the era of in‐home Internet connectivity, via telephone dialup. While we'd laugh today at the painfully slow data transmission rate, AOL was the pioneer leading us to today's overloaded email inbox. Our point here is that the venture capitalists themselves were instrumental in the investment going from a total loss to a return in the billions.

So, were the VCs right or wrong about their initial investment in Control Video? Notwithstanding misguided early steps, the key VC investors had the vision to see that the personal computer was coming to desktops broadly, that low‐cost communications modems would get faster and cheaper, and that the convergence of personal computers and ultimately higher speed modems would result in an online information and communications explosion. They got the central business idea right, but it took several tries, a different management team, and more capital investment to execute the idea. It also required patience, taking a number of years of effort as the pc/modem combo took time to be on everyone's desktop.

Timing, as in many VC investments, proved to be critical. If an investor invests too early in the market development cycle, a loss is likely; too late and a loss is for sure. Entry timing must often be just right for a high‐quality VC investment to emerge.

In the case of CVC/Quantum/AOL, the initial price proved not to really matter, as AOL became a historic home run. Price paid on investment tends to matter if the exit results in a single or double, or maybe even a home run that just barely clears the fence, but it matters a lot less in a grand‐slam exit. Investors in CVC/Quantum/AOL did, however, need great persistence and deep pockets to continue investing over a decade until success was achieved. Those that held the stock even after the company went public in 1994, at about a $70 million market capitalization, also needed the fortitude to hold the stock until 2001, the year of the merger with Time Warner, when the market capitalization hit a high exceeding $350 billion. In this case, patience, persistence, and creativity were the keys to the highest quality investment at what must ultimately be judged to have been the right price.

How to Manage Risk, Play the Odds, and Win in an Evolving Market

Now and again, as Jim Kimsey, former AOL chairman and CEO, used to say, “Finding a pony in a pile” is mostly lucky, and “making a pony from a pile” is even rarer. So, is there a key to successfully finding the highest quality VC investments at the right price—a proven method of seeking, finding, and closing these rare investment gems? How do the most successful VC investors find their way to the best deals and highest returns?

The first fundamental is to understand the essence of venture capital investing and how different it is from other classes of investments. Unlike Warren Buffett's investments, which leverage predictability, recognizing a company's greater intrinsic value relative to its price, whether through quick asset liquidation or sustained long‐term cash generation, a key element in venture capital investing is the inherent risk in each investment.

Because of that inherent risk, for many years the road to the highest returns was thought to be diversification of VC investments in a fund or investment pool. A venture capital firm, generally using institutional monies, would pool these funds and over four to seven years make 15 to perhaps 30 initial investments in the pool, and then make follow‐on investments in those ventures that were performing up to expectations and continued to show attractive potential. With this approach, generally about 85% of the investments made no money at all, another 10% or so perhaps doubled or tripled their money, and the remaining 5% or so—one to three investments—were true home runs, returning over ten times the money invested.

This diversified approach returned about 12% annually on average for all VC investing over about a 50‐year period. This proved to be a reasonably predictable investment approach, particularly if investments were made over a number of funds over different economic cycles. One fund might have a negative return, another in the middle, and another a home run fund. There was high volatility among the pieces, but reasonably predictable returns in the aggregate for the risk.

Recently, this extreme diversification approach has come under fire from a number of highly successful venture capital investors, including the famed PayPal founder and Facebook investor, Peter Thiel. Thiel argues in his insightful book, Zero to One (published in 2014 by The Crown Publishing Group), that, rather than following such a diversification method, which accepts that 80–85% of all the deals will fail, one would do better by making fewer investments in the first place, and then going on to focus intensively all effort and capital on the few that appear increasingly likely to become the home runs. He advocates far greater selectivity right from the start, only investing in the first place in ideas and companies that appear to have true home run potential.

For this home run method to work, the investor must have access to and the ability to spot or create likely home run investments, and not just one but rather seven or eight to have the house odds of at least one true home run materializing. We subscribe to this same philosophy. That's why we review literally a hundred or more opportunities for every deal we ultimately select for investment.

Prior to 2000, there were a number of investment banks that would undertake an initial public offering (IPO) for a fledgling company that, while having revenue, still had no earnings. In fact, at the height of the Internet bubble, even revenue was often not needed. Some of these companies could result in a single, a double, or perhaps even a triple for the IPO investor. Again, a broad portfolio diversification could work to achieve a 12% annual average IRR.

Unfortunately, though, many IPO investors were not so diversified and lost heavily. After the dot‐com bubble burst in 2000, many of these investment banks went out of business, so these smaller IPOs were no longer possible. Without them, the likelihood that the traditional venture portfolio diversification strategy would work, or was even readily feasible, disappeared.

During this same period, as more and more capital went into venture capital investing to feed the Internet frenzy, driving valuations and share prices ever higher, it became necessary for VC firms to invest larger and larger amounts of capital in each investment. In this superheated investment climate, the only ventures that could produce major returns and permit a VC firm to stay competitive were the home runs.

What It Takes to Hit Investment Home Runs

How then can an investor new to venture capital succeed? If it really takes home runs, what features signal that an investment has such potential? The most probable route to investment success would seem to be to invest with a major venture capital firm that has had considerable success year in and year out for several decades. This is the way that institutional investors try to invest in venture capital.

For individual investors, however, other than the mega‐wealthy, this approach until now has been almost impossible, as the 25 or so most notably successful VC firms rarely admit individual investors. When they do, often in “sidecar” funds with their institutional investors, these funds are limited to the lucky, the best connected, and the few.

Accessibility to individuals is finally here, though, through the establishment over the past few years of several online venture capital firms, including Angel List, Our Crowd, Funder's Club, Circle Up, and VCapital, founded by one of the authors (Len), with the other (Ken) serving in an advisory capacity. These online firms generally offer both individual investment deals and pooled investment funds.

Some of the firms perform extensive due diligence for greater selectivity in the investments they offer while others appear to perform somewhat less. Some of the firms have extensive experience in VC investing and some considerably less. Since online VC investing is so new, these online firms have little return history or realized IRR performance data based on actual exits to provide an investor with confidence. So the individual investor needs to understand the features and makeup of a likely home run investment, and how to track them down, or more realistically recognize the venture capital firms that have the ability to find those home run opportunities.

Hitting a home run requires the VC investor to see opportunity and potential before others do. If she's too late and that potential has already become evident to lots of others, the share price will have already escalated, making home run returns that much tougher.

In his quest to recognize opportunity (at the right price) before others do, Thiel likes the idea of considering, “What important truth do you see that very few people agree with you on?” To find those investment gems, Thiel's approach is to focus on a very large market or technical opportunity that few others see or understand well. If you see it first and others do not yet see it, or understand it better than others, you can start a company and build a strong, sustainable leadership position before anyone else is out of the gate.

The ventures that recognize those important truths also need “compelling economics.” The business idea or product needs to be at least 50% cheaper than the competition, or 50% faster, or 50% more compelling overall; a 100% advantage is even better. A good example is the authors' recent home run investment in Chicago‐based Cleversafe. Cleversafe's technological innovations in big data storage and security disrupted the data storage market by cutting data storage costs up to 80%, combined with significantly enhanced security, leading to IBM's recent acquisition of the company for $1.3 billion. Find a rare idea or product whose potential others do not yet see and will not see anytime soon, that has compelling economics, and the investors could be well on the way to a home run.

Visualizing this rare idea or product, in the words of the poet Tennyson, takes “seeing as far as the eye can see and knowing all the wonder that will be.” For a successful VC investor, a sense of wonder at all the possibilities is essential. But so also is a profound skepticism that all dreams come true, as most don't.

A VC investor must also discipline himself to visualize only about 10 to perhaps 15 years out, as this is about the patience limit of society and the financial community for high‐risk investments. A longer time horizon will permit competition not even dreamed of to emerge. Most technologies that will prove successful over the next 30 years have not yet even been imagined.

While 10 to 15 years may seem awfully long, the window for successful VC visualization itself can be short, as others' visualization can spawn competition that must be beaten to the prize. Entrepreneurs and the VCs who back them are under an imperative to act immediately. Acting immediately for the VC means recognizing quickly those entrepreneurs whose vision and execution of that vision will be successful. This, too, requires vision. Success tends to come to those who follow the old adage, “It takes one to know one.”

How to Find the Potential Home Runs

It may seem strange that, as venture capitalists, we see parallels in the path to success with the world's most notable traditional investor, Warren Buffett. Buffett's biggest investments have been in such traditional businesses as insurance companies, railroads, banks, newspapers, and the Coca‐Cola Company. So, where's the parallel with the venture capital focus usually on high tech, which Buffett historically avoided because he didn't understand it?

As we reviewed a few chapters back, Warren Buffett has been a successful investor for 50+ years for a number of reasons, foremost that he only invests in what he knows, understands, and is comfortable with. He committed to that approach as a young boy, when he took the money he made from a paper route and invested it in a farm. Buffett has looked at and made so many good investments over many years (and, he'll admit, some poor ones too, just not too many of them) that his odds of visualizing a good investment are much higher than average. He has also had to learn where and in whom to place his trust. This intuitive investment sense allows him to know which investment opportunities to trust when he sees them, and whom to trust as well.

Just like for Warren Buffett, the successful VC invests in what he knows, understands, and is comfortable with. For us, that includes high tech in industry sectors such as information technology and biotechnology, where our team has extensive knowledge and background. A big part of this is also knowing and trusting the source of the opportunity. Most high‐quality VC investment opportunities come to the VC through trusted sources—an attorney, accountant, broker‐banker, tax advisor, consultant, or entrepreneur who has a prior relationship with the VC. The referral source often knows what will interest a particular VC as to industry focus, stage, and investment dollar requirements, as well as knowing if a particular entrepreneur is “backable.”

Very few investments that are actually made come in blind over the transom. The old adage from Chicago politics not to hire anyone “that ain't sent” applies to VC investing as well. To find opportunities that could become successful investments, we listen carefully to trusted sources that have experience reviewing venture capital investments and often investing in them as well. Referral networks assist greatly in knowing whom to trust.

Knowing what to trust can be a bit trickier and brings into play both right‐ and left‐brain cognitive skills. The left brain has traditionally been viewed as the seat of logical processing. Logical data processing for venture capital investing requires a robust and reasonably accurate data set as well as effective linear processing skills. Processing speed, beyond a point, is not very relevant, as accuracy and resulting insight should be valued over speed. Often it's better to wait than to hurry, as new data comes to the fore and sheds new light on the investment.

Right‐brain processing is all about intuition. It is important to understand, though, that true intuition is based on experience. What one might call intuition, but which is separate from experience, is usually just wishing and hoping. That's not a smart basis for important investment decisions.

In VC investing, the logical processing work is mostly about deciding what data are most relevant to the decision to be made. Is the market size most important, or is what matters more the market growth rate, the superiority of the technology, the drive and persistence of the entrepreneur, the degree of difficulty in securing funds, the amount of funds required, speed to market, ability to scale quickly, potential for strong and sustainable leadership position, first‐mover advantage, or some particular combination of those variables? Once the most relevant and critical questions are determined, then it's “Just the facts, please!”

Accurate intuition is a function of both temperament and experience. For an early‐stage VC investor, including seed and startup investing, the most useful temperament tends toward a high comfort level with risk coupled with a hardheaded appreciation of the reality of likely failure. In early‐stage investing there are rarely any hard numbers or even clear, indisputable facts.

Experience is especially vital. Unfortunately, experience is often gained by losing a big pile of money. It is estimated that it takes at least $15 million in losses to train a successful professional VC investor.

The individual investor doesn't need to go through such a process of accumulating experience through costly losses, though some choose to. We believe that for most individual investors, it makes more sense to hitch your wagon to a professional venture capital firm with an experienced team with a meaningful track record.

We recognize, though, that some individual investors prefer more of a do‐it‐yourself approach. For them, the same concept may make sense as for the young, aspiring, professional VC. If that's your preference, our advice would be to start out with small investments and work your way up to larger ones as your experience grows. There are online sites for accredited investors where the investment requirement can be as little as $1,000. Under the new provisions of Title III of the JOBS Act, even non‐accredited individual investors can invest in venture capital on a limited basis, with these specific limitations:

• If either their annual income or net worth is less than $100,000, then the greater of $2,000 or 5% of the lesser of their annual income or net worth.
• If both their annual income and net worth are equal to or more than $100,000, investors are allowed to invest up to 10% of the lesser of their annual income or net worth.

Venture capital investing is both an art and a science. Science informs the art and art the science. But don't play aggressively until experience brings the skill to integrate art and science. The art is knowing whom to trust, when to trust, and what to trust.

Price Can Matter, Too, and Can Be Tricky

We've talked about the challenge of finding high‐quality investments. Of secondary importance, but still potentially important (since most investments don't turn out like AOL), is the price paid for the investment. In the earlier decades of venture capital investing, it was considered unusual to put a value on a company with revenue of more than twice that revenue. For those companies that had little‐to‐no revenue, a value of between $4 and $10 million was considered generous by VC investors. A $1 million investment might then buy 10–25% of the company's fully diluted stock.

During the rise of the dot‐com bubble, from 1995 to 2000, the price of early‐stage ventures became more expensive. For example, in one case investors paid at a $15 million valuation for a company that had about $5 million in forward projected revenue, although admittedly inclusion of investors and customers the likes of Microsoft, Visa International, William Blair, and Paul Allen's VC firm added to the perceived value. The company, Software.net, initially based in Palo Alto with three employees over a barbershop, was eventually split into two companies, CyberSource and Beyond.com. Both undertook successful IPOs, with the initial early‐stage investors in the combined entity receiving 41× their money invested in about three and a half years from the date of initial investment. So at the time of the initial investment, the $15 million valuation seemed high, but the reward of stepping up to the price was great. These were heady days for entrepreneurs and the valuations of their companies.

Beware, though, as valuations are constantly in flux in a VC market seeking the highest quality investments at low‐to‐fair prices. Valuations declined as the dot‐com bubble burst, with many companies unable to find financing at any price, and those that could having to give up more of the company for less.

Even during that difficult era, though, those companies that were in a particularly hot industry or addressed a large and popular market could still maintain higher values. VCs will often pay a higher price if the so‐called comparables are higher. Comparables are the exit values, either through an IPO or company sale or merger, of companies similar to the company being financed. The VC reasoning is that if a similar company will fetch an excellent price, then the company they are investing in should as well. No two companies are ever exactly similar, however, so with this valuation approach the investor should continue to beware.

A number of entrepreneurs have come to believe that the more traditional venture capital market will not treat them fairly as to valuation and will always seek to invest at the lowest possible price. These entrepreneurs then seek out other sources of financing, including angels, angel groups, and online funding.

While tough pricing and terms are often a feature of venture capital financing, venture capitalists will often pay up for a highly competitive deal that others are actively seeking. Pricing is essentially set by the supply and demand in the marketplace for VC funding, so it's essential for entrepreneurs to test the market for their stock through discussions with a number of potential investors and sources.

Today some VC firms view it as a competitive advantage in attracting the best and brightest entrepreneurs to be considered “nice” and willing to pay fair value. Frankly, fair pricing—not inflated or excessively low—makes sense for both sides of the transaction. If the share price is too high, then early‐stage investors may insist on protection against ownership dilution in later funding rounds, which would likely come at the expense of the management team's ownership share. On the other hand, if the share price is too low, the entrepreneur and his team could lose motivation.

Need to Consider Non‐monetary Costs, Too

There are both monetary costs and less readily quantified non‐monetary costs in venture capital investing. For a venture capitalist, like for most businesspeople, time is money. If an investment is expected to take less time to exit and/or less of the venture capitalist's time in working on and adding value to an investment, the VC may be willing to pay a higher price. Also, if the investment is further along the development curve, either already having revenue or about to achieve revenue, the price paid will likely be higher, as the perceived risk of loss is lower.

If the perceived risk of loss is considered high, on the other hand, then the VC will generally require a lower price. That lower price is needed to offset the human cost of the time that will likely be required from the VC, as well as the economic cost to the VC to compensate for the greater likelihood of a loss, which can also be quite high as to reputation both inside and outside the VC firm. Considering the human cost component, the VC needs to consider his potential required time commitment relative to using that time either to raise additional funds for the firm or to make new investments, so it is a real opportunity cost that must be considered.

Some Pricing Advice for the Entrepreneur

Experienced venture capital investors have a good idea of which industries are in fashion, and of the risk/reward profile for the particular industry and stage of the deal. They will also have a good idea of what price the deal may bring from another VC. Generally, it's best to find an investor who will pay a fair price (not necessarily the highest) and who brings other added value to the investment, including a workable, if not close, relationship with the entrepreneur.

The following approach has worked well for many aspiring fundraisers:

• Bring your deal along to the highest stage possible on your own prior to seeking venture capital. This will help maximize your price.
• Discuss possible valuations of your deal with your attorney, accountant, investment banker, and any friendly venture capitalists prior to establishing the price.
• Select a valuation that is reasonable in light of market realities, a bit on the higher side perhaps, so there is room to negotiate. Not so high, though, that the venture capitalist will feel that working with you is a waste of time.
• Try the valuation on several VCs, including at least one who would be a good prospect as a lead investor.
• If the valuation fails to pass “the snicker test” with several venture capitalists, revise the valuation downward.
• Remember that most VC‐funded ventures require more than one round of equity infusion prior to positive cash flow or exit. Don't sell so much of the company that there is none left for the team.

If you sell one‐third of your company for $1 million, the valuation or value of your company, at least on paper, is set at $3 million. Remember, the higher the perceived quality, the more likely the higher the price.